What is a Bond?
A bond is a form of debt in which an investor serves as the lender. Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank. The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or paying off other debt.
How do Investors Make Money on a Bond?
Your typical bonds will generate income for investors in one of two ways: periodic interest payments or purchasing the bond at a discount. There are also bonds where a combination of the two are applicable but we will explain each separately.
There are interest rates associated with the bonds and interest payments are made periodically to the investor (i.e. semi-annual). When the bonds are issued, a promise to pay the interest over the life of the bond as well as the principal when the bond becomes due is made to the investor. For example, a $10,000 bond with a 5% interest rate would pay the investor $500 annually ($250 semi-annually). Typically tax would be due on the interest each year and when the bond comes due, the principal would be paid tax free as a return of cash basis.
Purchasing at a Discount
Another way to earn money on a bond would be to purchase the bond at a discount and at some time in the future get paid the face value of the bond. A simple example would be the purchase of a 10 year, $10,000 bond for a discounted price of $9,000. 10 years from the date of the purchase the investor would receive $10,000 (a $1,000 gain). Typically, the investor would be required to recognize $100 of income per year as “Original Issue Discount” (OID). At the end of the 10 year period, the gain will be recognized and the $10,000 would be paid but only $100, not $1,000, will have to be recognized as income in the final year.
Is There Risk in Bonds?
Investment grade bonds are often used to make a portfolio more conservative and less volatile. If an investor is less risk oriented or approaching retirement/in retirement they would be more likely to have a portfolio with a higher allocation to bonds than a young investor willing to take risk. This is due to the volatility in the stock market and impact a down market has on an account close to or in the distribution phase.
That being said, there are risks associated with bonds.
Interest Rate Risk – in an environment of rising interest rates, the value of a bond held by an investor will decline. If I purchased a 10 year bond two years ago with a 5% interest rate, that bond will lose value if an investor can purchase a bond with the same level of risk at a higher interest rate today. This will make the bond you hold less valuable and therefore will earn less if the bond is sold prior to maturity. If the bond is held to maturity it will earn the stated interest rate and will pay the investor face value but there is an opportunity cost with holding that bond if there are similar bonds available at higher interest rates.
Default Risk – most relevant with high risk bonds, default risk is the risk that the issuer will not be able to pay the face value of the bond. This is the same as someone defaulting on a loan. A bond held by an investor is only as good as the ability of the issuer to pay back the amount promised.
Call Risk – often times there are call features with a bond that will allow the issuer to pay off the bond earlier than the maturity date. In a declining interest rate environment, an issuer may issue new bonds at a lower interest rate and use the profits to pay off other outstanding bonds at higher interest rates. This would negatively impact the investor because if they were receiving 5% from a bond that gets called, they would likely use the proceeds to reinvest in a bond paying a lower rate or accept more risk to earn the same interest rate as the called bond.
Inflation Risk – a high inflation rate environment will negatively impact a bond because it is likely a time of rising interest rates and the purchasing power of the revenue earned on the bond will decline. For example, if an investor purchases a bond with a 3% interest rate but inflation is increasing at 5% the purchasing power of the return on that bond is eroded.
Below is a chart showing the risk spectrum of investing between asset classes and gives a visual on the different classes of bonds and their most susceptible risks.
Types of Bonds
Bonds issued by the federal government are backed by the full faith and credit of the U.S. Government and therefore are often referred to as “risk-free”. There are always risks associated with investing but in this case “risk-free” is referring to the idea that the U.S. Government is not likely to default on a bond and therefore the investor has a high likelihood of being paid the face value of the bond if held to maturity but like any investment there is risk.
There are a number of different federal bonds known as Treasuries and below we will touch on the more common:
Treasuries – Sold via auction in $1,000 increments. An investor will purchase the bond at a price below the face value and be paid the face value when the bond matures. You can bid on these bonds directly through www.treasurydirect.gov, or you can purchase the bonds through a broker or bank.
Treasury Bills – Short term investments sold in $1,000 increments. T-Bills are purchased at a discount with the promise to be paid the face value at maturity. These bonds have a period of less than a year and therefore, in a normal market environment, rates will be less than those of longer term bonds.
Treasury Notes – Sold in $1,000 increments and have terms of 2, 5, and 10 years. Treasury notes are often purchased at a discount and pay interest semi-annually. The 10 year Treasury note is most often used to discuss the U.S. government bond market and analyze the markets take on longer term macroeconomic trends.
Treasury Bonds – Similar to Treasury Notes but have periods of 30 years.
Treasury Inflation-Protected Securities (TIPS) – Sold in 5, 10, and 20 year terms. Not only will TIPS pay periodic interest, the face value of the bond will also increase with inflation each year. The increase in face value will be taxable income each year even though the principal is not paid until maturity. Interest rates on TIPS are usually lower than bonds with like terms because of the inflation protection.
Savings Bonds – There are two types of savings bonds still being issued, Series EE and Series I. The biggest difference between the two is that Series EE bonds have a fixed interest rate while Series I bonds have a fixed interest rate as well as a variable interest rate component. Savings bonds are purchased at a discount and accrue interest monthly. Typically these bonds mature in 20 years but can be cashed early and the cash basis plus accrued interest at the time of sale will be paid to the investor.
Municipal Bonds (Munis) – Bonds issued by states, cities, and local governments to fund specific projects. These bonds are exempt from federal tax and depending on where you live and where the bond was issued they may be tax free at the state level as well. There are two categories of Munis: Government Obligation Bonds and Revenue Bonds. Government Obligation Bonds are secured by the full faith and credit of the issuer’s taxing power (property/income/other). These bonds must be approved by voters. Revenue Bonds are secured by the revenues derived from specific activities the bonds were used to finance. These can be revenues from activities such as tolls, parking garages, or sports arenas.
Agency Bonds – These bonds are issued by government sponsored enterprises such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac). Agency bonds are used to stimulate activity such as increasing home ownership or agriculture production. Although they are not backed by the full faith and credit of the U.S. Government, they are viewed as less risky than corporate bonds.
Corporate Bonds – These bonds are issued by companies and although viewed as more risky than government bonds, the level of risk depends on the company issuing the bond. Bonds issued by a company like GE or Cisco may be viewed by investors as less of a default risk than a start-up company or company that operates in a volatile industry. The level of risk with the bond is directly related to the interest rate of the bond. Generally, the riskier the bond the higher the interest rate.
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.