Most investors own bonds for income, diversification, and to reduce risk; all very important reasons. However, most of these investors do not understand how a bond works.
Bondholders are lenders
A bond consists of two basic obligations on the part of an issuer: to pay a stream of income over a period of time in the form of interest payments; and to pay the bondholders money back upon maturity. Therefore, it is important to know the issuer of the bond and their ability to live up to these two obligations before you invest.
A bond issuer can be anyone who might need to borrow money to finance a building, project, or business. A bond is a loan and an obligation against that issuer. This loan might be secured by the entire business or entity, or by certain assets or revenues.
Know who and what is securing your bond. The federal government issues several forms of bonds, and is considered to have the highest credit worthiness. Municipal bonds may be issued by cities, states, or schools districts and generally provide income that is not subject to federal income tax; this makes them attractive to investors with high taxable income. You might be loaning your money to a municipality for roads, water plants, schools, or other projects that require large amounts of money to build or operate.
Corporate bonds are issued by companies to fund items such as; new buildings, new equipment, or even general operations. These corporations can range from small to large, and young to very established blue chip corporations.
How do you decide who to loan your money to? Much like a bank checks your credit score, bonds are usually assigned a credit rating by one of several companies including Moody’s, Standard & Poors, or Fitch. Some bonds are sold without a credit rating. These bonds, classified as non-rated, should be considered higher risk, and are for more sophisticated investors.
Building a bond
Understanding bonds was easier when you held a paper certificate that stated the issuer, the maturity date, and the coupon or interest rate. Today, most bonds (including all government bonds) are held in street name, so you never actually see a certificate.
The term coupon originated because these certificates had “Coupons” attached that represented the scheduled interest payments. You would physically clip off a coupon, present it to the bank, and receive your interest. Most bonds pay every six months, so a ten-year bond would have twenty coupons attached. You could see all of the scheduled payments and the amount you would receive.
Even though you no longer see the coupons, scheduled payments are still credited to the bondholder’s bank or investment account.
Why does the value of my bond go up or down?
Here lies the mystery of investing in bonds. Several factors might influence the price of a bond, but change in interest rates is the most common. When interest rates go down, bond prices go up. When interest rates go up, bond prices go down. This inverse price relationship is created when a value is placed on the future stream of income payments. The longer the maturity date, the more the bondholder depends on the value of the interest payments. With a short maturity date of five years or less, your return on investment depends more on the return of your investment (principle). A maturity date of twenty to thirty years, means your return on investment will depend more on the total dollars received from the interest payments.
Example: a $10,000 30-year bond at 4% would pay out $12,000 of interest ($400 x 30 years). If interest rates move up to 6%, a new thirty-year bond would pay out $18,000 of interest ($600 x 30 years), which is a 50% increase to the bondholder. Therefore if interest rates move up from 4% to 6%, the original bond would have less value based on the total future income compared to the current market. The longer the maturity date the greater the price fluctuation.
If you believe interest rates are going to rise, you might prefer to own short-term bonds. If you believe interest rates are going to fall, you may want to lock in on current interest rates until a longer maturity date.
Paul R. Attwater III is a Financial Advisor at Morgan Stanley Smith Barney, a division and service mark of Citigroup Global Markets, Inc. Member SIPC. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Smith Barney or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results.
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