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| Aug 01, 2016
The U.S. bond market is estimated to be approximately $40 trillion. Since media attention is often focused on stock investing, many investors do not fully understand bonds and bond markets. That’s why we’ve provided a general overview on bonds with some quotes from another familiar character named Bond to keep things “shaken, not stirred.”
Bonds defined
“We’ve got three minutes.” Dr. No (1962)
First things first—and as briefly as possible, 007—let’s define bonds. In the investment world, there are two types of security investments: debt and equity. Bonds are a form of debt and may be issued by a corporation or government while only a corporation may issue equity, or stocks. A bond is a loan. It reflects a promise by the borrower (the issuer of the bond) to repay the amount borrowed on a specific date in the future, plus interest at an agreed upon rate. Bonds are bought by mutual funds, investment managers, pension funds, insurance companies, commercial banks, state and local governments, central banks and individuals.
Because bondholders are creditors, the issuer is legally bound to pay the loan. In the event that an issuer files for bankruptcy, bondholders’ claims on the assets take priority over those of stockholders. After all bondholder claims are satisfied, any remaining proceeds from the liquidation are claimed first by preferred stockholders and lastly by common stockholders.
Types of bonds
“What do you know about gold, Moneypenny?” Goldfinger (1964)
There are four common types of bonds available to investors.
- Federal government bonds, also referred to as Treasury securities, are issued by the Treasury to help finance various federal government operations and are considered the safest investment in the world.
- Government-sponsored enterprises are bonds issued to finance activities supported by public policy, such as home ownership and farming. Higher risk as they are not guaranteed, they borrow at higher interest rates compared to the Treasury. Fannie Mae and Freddie Mac are two examples of these types of bonds.
- Municipal bonds are issued by states, cities, counties and other municipalities to fund public projects like schools, roads, sewer systems and convention centers. Many offer income that is exempt from both federal and state taxes.
- Corporate bonds allow corporations to raise money through the issuance of debt for projects like market and plant expansions or new product ideas, and typically offer higher yields than comparable government bonds.
Why invest in bonds?
“You're the scientist. You tell me.” The World is Not Enough (1999)
More than stocks, bonds can offer predictable cash flows, enable diversification and lead to better financial security. But there are several things to consider before investing in bonds, including maturity, the date on which a bond will be repaid; redemption provisions; tax status; and risk associated with interest rates and credit.
Credit risk is associated with the issuer’s ability to make timely principal and interest payments to bondholders. Bonds, with the exception of Treasury securities that are considered risk-free, may be evaluated and graded for risk on an alphabetical scale by Standard & Poor’s and Moody’s Investment Service.
With interest rate/market risk, bonds have an inverse relationship with interest rate movements, meaning that often, as rates rise, bond prices fall, and vice versa. Interest rate risk is a factor of things like supply and demand of credit, Federal Reserve policy, fiscal policy, exchange rates and inflation. This interest rate/market risk can be offset by other factors like maturity date and coupon rates.
What’s a coupon rate?
“I fell out of an airplane without a parachute. Who's in there?” Moonraker (1979)
The essential components of a Bond movie are our hero, the villain and the Bond girl; the essential components of a bond investment are maturity, par value and coupon interest rate. Par value refers to the amount the bondholder will be repaid when the bond reaches maturity, while coupon rate is the percentage of par value that will be paid to the bondholder on a regular basis.
For example, if James Bond buys a bond for $1,000, it has a par value of $1,000. With a coupon rate of 6 percent and a 10-year maturity, James Bond is entitled to receive 6 percent per year for 10 years, or $60 a year, usually paid in two semiannual installments, or $30 each. Martinis on James Bond!
Bond maturities generally vary from three months to 30 years with shorter-term bonds maturing at up to two years, intermediate-term bonds maturing between two and ten years and long-term bonds maturing after more than 10 years.
Measuring return
“In my business you prepare for the unexpected.” License to Kill (1989)
Bond prices don’t always equal bond yields. In our previous example, James Bonds’ 10-year, $1,000 bond is always going to pay him $60 a year. But the price he actually pays for the bond could be higher or lower depending on demand. If all of the other double O’s want to buy the same bond, resulting in high demand, that bond may be trading at a premium to its par value. In that case, Bond might have to bid more than $1,000 for the $1,000 bond—but it will still pay out at $60 per year even if he bids more. So, in that case, the yield would drop with the increase in price. And that might make Mr. Bond quote himself from On Her Majesty’s Secret Service (1969), saying, “This never happened to the other fellow!”
We hope this helps you better understand the basics of bonds. Subscribe to our blog for more on bonds and other investment and wealth management topics.
