At Stock Rover, we specialize in tools and data primarily for equity research, but we also aim to provide well-rounded investment education to novice and intermediate level investors. So here is a brief primer on bonds, a very popular alternative investment instrument to equities.
You can buy and sell individual bonds through most brokerage houses. Although you can’t research bonds in Stock Rover, you can track those that you own in your portfolio. If you have linked your portfolio in Stock Rover to your brokerage, bonds should appear automatically in your portfolio as an asset. Or if you are manually updating your portfolios in Stock Rover, just edit “Other Assets” in the Update Portfolio window.
A bond is a debt security. Basically, it’s an IOU. When you buy a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer.
In return for that money (the principal), the issuer provides you with a bond in which it promises to pay a specified rate of interest (known as the coupon) during the life of the bond and to repay the face value of the bond when it matures, or comes due. This means you get a steady predictable stream of income while you have lent out your principal.
Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds.
Bonds can be also called bills, notes, debt securities, or debt obligations. They are traded in units of $1,000.
The risk of buying bonds is that the issuer could default and you might not get the principal back. As with stocks, riskier bonds can offer more reward (a higher coupon), but are also more likely to default.
Bond ratings help you identify bonds with the lowest likelihood of default. The riskiest bonds, with a rating of BB or lower, are called junk bonds. On the other end of the spectrum, U.S. Treasury bonds have the highest rating and are generally considered the safest type of investment, sometimes referred to as a “risk-free” investment, because they are guaranteed by the U.S. government. The potential return of any non-risk-free investment can be compared to this risk-free rate in order to estimate the risk premium, as we did here in this blog post.
Note also that some bonds are callable. A callable bond can be called back, or redeemed by the issuer before the bond is due. Getting a bond called is undesirable, because it means a bunch of money is dumped on you that you need to reinvest, generally at less attractive rates (which is why the bond would get called in the first place—the market rate would have become more favorable to issuers). Because being callable is an undesirable feature for the buyer, callable bonds tend to have higher coupons.
Bonds are usually callable at or slightly above par. Par is face value of the bond (i.e., the amount of the principal that you lent). If a bond is callable at par, that means all of principal is returned. Or the bond could be callable at something like $102, which means the issuer pays an additional 2% penalty to call the bond, so you would receive $102 for every $100 of principal you lent (or $1,020 for every $1,000).
Bonds are primarily valued on the following five things:
You could buy a $100,000 Massachusetts G.O. (general obligation) bond. G.O.s are guaranteed by Massachusetts state tax revenues. Let’s say our Mass G.O. bond has a 20-year life and pays an interest rate of 4%. Note that the bond interest is federal tax free and is also state tax free if you live in Massachusetts. The interest (AKA the coupon) is paid twice a year. So you get $2,000 every 6 months. At the end of 20 years, the principal is returned to you and the bond expires. If the bond is callable, it could be called back anytime on or after the first call date of the bond, which is stated by the bond issuer. A typical call date for a 20 year bond might be 6 years after the issue date, though this varies widely.
For trading purposes (i.e., if you want to sell your bond to another buyer), the par value is often quoted on a scale of 100. So if par is 100 and by the time the bond goes on sale, interest rate conditions may have changed—say rates have increased. Now instead of the 4.0%, investors want a 4.2% return in order to buy that same Mass G.O. bond. The bond would need to priced at a discount to par in order to sell. So in this case, it would sell at 95.24, a discount to par, and they buyer would spend $95,240 to purchase that $100,000 bond. The amount paid at maturity is still the amount shown on the certificate, which in this case would be $100,000.
Here are two common bonds that are structurally different from a typical bond:
We hope you enjoyed this short course on bonds. Look out next week for our primer on Mutual Funds.
An EXCELLENT summary.
Thanks for the update on bonds. Always good to refresh one’s knowledge.
How about comets and how commissions are determined for those trading bonds?
Brokers mark up bonds, which is how they get paid and how they make their commission. The fees depend on the broker and on the bond. It wouldn’t be a stretch to say brokers can make a lot of money when clients trade bonds. An investor would need to ask the broker what the markup fees are for bond trading to in order to understand these costs.
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