You may have some sense of what a bond is, but if you’re curious about the specifics, this note is for you. It is all about bonds.1. What is a bond?
- It’s a contract between a borrower (aka “issuer”) and a lender (aka “investor”) in which the borrower agrees to repay the funds in a structured manner.
- Typically, the borrower makes semi-annual interest payments (aka “coupon”) and then repays the principal in full at the end of the term of the bond (aka “balloon payment”).
2. Who issues them?
- US federal government
- State and local governments (aka “municipal” or “tax-exempt” bonds)
- Sovereign governments
- Public agencies controlled by these governments
3. What are some important features?
- Term — bonds can be for different time periods, typically between two and 30 years.
- Creditworthiness — investment-grade bonds are least likely to default and junk bonds (more politely known as “high-yield”) are most likely at risk of a default. US Treasury bonds are considered the safest as they are backed by the “full faith and credit” of the federal government.
- Taxability — generally, interest payments on federal government bonds are exempt from state income taxes; municipal bonds are exempt from federal and state income taxes (in the issuing state); and corporate and sovereign government bonds are subject to all income taxes.
4. What are other types of debt securities?
- Mortgages are repaid monthly with a fixed payment that is a combination of interest and principal.
- Zero-coupon bonds are as they sound. Instead of semi-annual interest payments, the interest is paid in full at the end of the term, along with the re-payment of the principal.
- Commercial paper is a short-term zero coupon bond, issued by corporations or municipalities, typically with a one to six month term.
- Treasury Bills are like commercial paper, issued by the US government.
- US savings bonds are zero-coupon bonds for the public. You may have some tucked away from your bar mitzvah, quinceañera, or wedding.
5. Why do interest rates change?
That’s the stuff of Phd dissertations. Here’s a simple version:
- Think of just two interest rates — short-and long-term.
- To control inflation and minimize unemployment, the Federal Reserve Bank (aka “the Fed”) adjusts short-term rates through a variety of technical mechanisms.
- The Fed lowers or raises the short-term rate when it wants to stimulate or decelerate the economy. Raising rates tend to dampen future inflation (by slowing the economy) while lowering rates tends to stimulate macroeconomic growth.
- Long-term rates derive from expectations about the Fed’s future intentions for short-term rates, plus a premium for incurring more risk because of the longer time period.
6. How safe are bonds?
They’re usually safe (until they’re not).
The interest and principal repayment of a bond is contractually guaranteed and if not paid in full and on time, a legal claim will be initiated by the creditors.
If the issuer declares bankruptcy, bondholder claims typically have priority over other claimants so they are likely to receive some value when it is resolved. It can be a messy and contentious process.
Besides Argentina, other examples of troubled bonds that have been in the news include: Greece, Puerto Rico, Detroit, Toys R Us, and Sears.
7. How does investing in bonds compare to stocks?
Bonds offer lower returns than stocks. Over the past 100 years or so, stocks averaged 9% annual returns and long-term bonds averaged 6% returns. Inflation and short-term bonds each averaged about 3%.
Bonds also offer less risk — when they decline in value, their dips are typically smaller than with stocks.
8. How do you buy/invest in them?
Investors can buy individual bonds but it’s not a good idea. Transaction costs can be significant and the choices can be overwhelming. Instead, invest through a mutual fund and leave the trading to the pros.
There’s a wide variety of bond mutual funds to suit any investor’s goals:
- Long- and short-term
- Tax-exempt and taxable
- Investment grade and high yield
- Government and corporate
9. What’s a good benchmark bond to track?
If you want to follow just one bond to get a sense of interest rates, use the 10-year US Treasury.
- Home mortgage rates are loosely tied to it.
- It’s reported in the media.
- Other countries’ 10-year government bond rates also are reported.
Here are current 10-year government bond rates in various countries:
- Greece: 4.3%
- Italy: 3.5%
- US: 3.2%
- Canada: 2.5%
- UK: 1.6%
- France: 0.8%
- Germany: 0.5%
- Japan: 0.1%
- Switzerland: 0.0% (!)
Why do bond rates vary so much across industrialized countries and why does any rational person invest in Japanese or Swiss government bonds when they yield 0%? Those are mysteries for another day.
Have questions about your bond investments? Contact me.