A Beginner’s Guide To Understanding How To Invest In Bonds
You may have some sense of what a bond is, but if you’re curious about the specifics, this note is for you. Investing in bonds generally offer less risk and lower expected returns compared to stocks. We’ll cover the long and short of bonds.
What is a bond?
A bond is 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”).
The interest rate is determined by the interplay of the term of the bond, the riskiness of the issuer, the taxability of the interest payments, and whether there are any secured assets as collateral. Bonds are typically issued by:
- US federal government
- State and local governments (aka “municipal” or “tax-exempt” bonds)
- Sovereign governments
- Public agencies controlled by these governments
- Private corporations
What are some important features?
- Term — bonds can be for different time periods, typically between two and 30 years.
- Creditworthiness — this is a measure of how likely a bond is to default. US Treasury bonds are considered the safest as they are backed by the “full faith and credit” of the federal government. Bonds issued by state governments in the US are considered almost as safe as US Treasuries as there is no legal mechanism for a state to default on its debts. Sovereign debts (i.e., those of foreign governments) may be significantly less safe than US Treasuries, depending on the country, the currency, and under what legal system they were issued.
- 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.
- Security — some bonds (like US Treasuries) have no assurance of repayment other than the guarantee of the issuer (aka “full faith and credit”); other bonds are secured by collateral which may be physical assets or, in the case of government issuers, future tax collections.
What are junk bonds?
These are bonds where the issuer has a poor credit rating and there is a significant risk of default. In more polite company, they are known as “high yield” bonds. As you might expect, investors in these bonds are compensated with higher interest rates because there’s a higher likelihood that they may not receive all the future bond payments or full return of the principal that have been promised. Are they a good investment? They can be if the higher risk has been properly compensated with higher expected returns. They also offer good diversification with other investment assets.
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 repayment of the principal. These bonds are sold at a discount to the end-of-term principal value, reflecting the implied interest rate.
- 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.
Why do interest rates change?
That’s the stuff of Phd dissertations. Here’s a simple version:
- Think of just two government interest rates — short-and long-term.
- To control inflation and minimize unemployment, the Federal Reserve Bank (aka “the Fed”) controls and 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 or restrain inflation. 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.
What is the yield curve?
A yield curve expresses the different interest rate levels for the same kind of bond over different maturities. Most commonly, the yield curve refers to comparing the yield of US government bonds with different maturities that typically range from 30 days to 30 years. Imagine a graph with the y-axis being the yield (or interest rate) and the x-axis being time, going from 30 days to 30 years.
A normal yield curve rises over time with long-term interest rates being higher than short-term ones. That is the typical condition in an economy. Most investors/lenders want a premium to compensate them for incurring more risk over a longer period.
An “inverted yield curve” is when, as you might expect, the opposite happens. For unusual reasons, short-term interest rates are higher than long-term ones. Why might this happen? A simple explanation is that investors foresee an economic slowdown is looming in the future and thus the Federal Reserve Bank will act to lower interest rates to respond. Thus, longer-term rates are already incorporating that expectation.
A flat yield curve is one in which interest rates are the same level at any time period.
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. And, secured bondholders (i.e., those with an asset pledged as collateral), have priority over other bondholders. It can be a messy and contentious process.
In one notorious example, an American hedge fund tried to seize an Argentine naval vessel docked in a Ghanaian port to compensate them for defaulted Argentine government bonds that they owned. This is when, in a twisted sense, bonds do have more fun.
Besides Argentina, other examples of troubled bonds that have been in the news include: Greece, Puerto Rico, Detroit, Toys R Us, and Sears.
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.
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. There also may not be a lot of liquidity if you need to sell them. 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
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 as it has several useful features:
- It’s widely traded and thus quite liquid.
- 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 yields for 10-year government bond rates in various countries:
Why do bond rates vary so much across industrialized countries and why does any rational person invest in government bonds when they offer a negative yield? Those are mysteries for another day.