Growing up as a child, I vaguely remember being gifted paper U.S. Savings Bonds by my great uncle. This was my introduction to bond investing. I didn’t know exactly what they were at the time, but I was told that when we put a bond in a safe deposit box, it would become more valuable over time.
That was probably around 1980, when interest rates were sky high. Fast forward to today and things have certainly changed. Folks can still buy savings bonds, but there is rarely a massive paper trail involved. Instead people buy bonds online through a broker or directly from an issuer. In the case of a savings bond, the U.S. Government issues the bond. Anyone can buy bonds from Uncle Sam today at TreasuryDirect.gov.
And the general climate revolving around bond investing has changed as well. Once at stratospheric levels, during the past three decades, interest rates have tumbled to the point where we refer to today’s environment as ZIRP – zero interest rate policy.
While one might reference the “fixed-income” market or bonds in general, bonds are far from a homogenous investment. Though most work the same way, representing a contract between a bond buyer and issuer, there are a multitude of types of bonds that an investor can buy.
Bond investing is generally thought of as income investing. When investor A buys a bond from Company or Entity XYZ, XYZ guarantees that over the term of the bond (length of the contract) it will pay Investor A a stated, or fixed rate of interest, referred to as a “coupon,” typically two times a year for a stated number of years.
So Investor A may buy a bond from XYZ that pays 5% interest a year for ten years. If Investor A buys a $10,000 face value bond from XYZ, they will receive $250 every six months for ten years. Over the life of the bond, Investor A will receive $5000 in interest payments.
Bonds are typically issued by companies or for-profit entities wishing to expand. Sometimes they are issued by sovereign nations around the world, by school districts, municipalities or by U.S. States. A tax-sensitive investor may really like those State and school district bonds because the interest paid is generally tax free. Most of the time tax-free bonds are referred to as “munis.” The trade off for the tax free nature of munis. is that they typically pay a lower rate of interest compared to a taxable bond with same or similar credit and maturity.
What is credit, you ask? Most bonds are issued a rating by one of several credit agencies that monitor the fixed-income market. The stronger the entity’s current financial picture is, the better its credit rating will be. Standard & Poors, or S&P, one of those agencies, rates on a scale from “triple A” (AAA), down a sizable number of rungs to “D” or default. Default occurs when a borrower fails or is unable to make their interest payment to the lender by a specified time. Bankruptcy may be in the cards for such an entity.
Bond issuers with better credit generally borrow money at lower rates. If XYZ tech company, which has very good credit, wants to borrow money for 10 years, it will pay far less interest than tech company ABC that hasn’t been around for a while, has a generally shaky balance sheet, or weak revenue/earnings trends.
Issuers with below investment grade credit issue what are know affectionately as “junk” bonds. Though the name implies that you shouldn’t own them, sometimes there is tremendous value in higher-yielding bonds, especially if the company is focused on improving their balance sheet over the near-term.
The amount the borrower will pay is also determined by the length of time until the bond matures, or comes due. The longer the maturity, the more the borrower will pay. If XYZ pays 2% interest for a 5-year bond, it might have to pay 3% for a 10-year bond. Issuers with good credit, looking to borrow money for short periods will pay little interest, while borrowers with junk credit looking to borrow for long periods of time will pay high levels of interest.
When a bond matures, the borrower not only makes their final interest rate payment to the lender, they also return the amount of capital they borrowed. So if an investor buys $10,000 of a bond on Aug. 1, 2015 with 5 year maturity, the bond comes due on August 1, 2020. At that point the issuer gets their $10,000 back.
Not all bonds pay interest on an annual basis. A minority of bonds are called “zero coupon” bonds, which means that whatever interest is accruing is paid in full at the bond’s maturity date and not intermittently during the life of the bond.
Given the low interest rate environment of today relative to yesteryear, there is not a lot of comparative value in bond coupons (interest rates). Still, investment grade bonds offer portfolio diversification, predictable cash flow, and guaranteed return of capital (barring interim problems) at maturity. In the event of a stock market sell off, bonds can also provide total return value as a “flight to quality.” While not given a lot of press, bonds provide flexibility and can be purchased with parameters that can be matched to the risk an investor is willing to take.