What Is a Bond and How Do Bond Investments Work?

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What Is a Bond and How Do Bond Investments Work?
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What Is a Bond?

• A bond, in its basic form, a plain vanilla bond
  is a type of loan.
• An investor takes his or her money and
  temporarily lends it to the bond issuer.
• In exchange, the investor receives interest
  income at a predetermined rate (the coupon rate)
  and at predetermined times (the coupon date).
• The bond has an expiration date (the maturity
  date) at which point the stated par value of the
  bond must be returned.
• In most cases, with a notable exception being
  certain U.S. Government savings bonds such as the
  Series EE savings bonds, a bond ceases to exist
  at maturity.

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Example Of Bond

• Imagine The Coca-Cola Company wanted to borrow
  10 billion from investors to acquire a large tea
  company in Asia.
• It believes the market will allow it to set the
  coupon rate at 2.5 for its desired maturity
  date, which is 10 years in the future.
• It issues each bond at a par value of 1,000 and
  promises to pay pro-rata interest semi-annually.
• Through an investment bank, it approaches
  investors who invest in the bonds.
• In this case, Coke needs to sell 10,000,000 bonds
  at 1,000 each to raise its desired
  10,000,000,000 before paying the fees it would
  incur.

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Different Types of Bonds

1. Sovereign Government Bonds
2. Municipal Bonds
3. Corporate Bonds

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Sovereign Government Bonds

• These are bonds issued by sovereign governments.
  In the United States, this would be things such
  as U.S. Treasury bills, bonds, and notes, which
  are backed by the full faith and credit of the
  country, including the power to tax in order to
  meet its constitutionally required obligations.
• Additionally, sovereign governments often issue
  special types of bonds aside from their primary
  obligations.
• Agency bonds, which are issued by government
  agencies, often to fulfill a specific mandate and
  despite enjoying the implicit assumption of
  backing from the government itself, often provide
  higher yields.
• Likewise, savings bonds, which we've already
  discussed, can be particularly interesting under
  the right circumstances e.g., the Series I
  savings bonds when inflation is a risk.

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Municipal Bonds

• These are bonds issued by state and local
  governments.
• In the United States, municipal bonds are often
  tax-free to achieve two things.
• Firstly, it allows the municipality to enjoy a
  lower interest rate than it would otherwise have
  to pay (to compare a municipal bond with a
  taxable bond, you must calculate the taxable
  equivalent yield, which is explained in the
  article linked earlier in this paragraph), easing
  the burden to free up more money for other
  important causes.
• Secondly, it encourages investors to invest in
  civic projects that improve the civilization such
  as funding roads, bridges, schools, hospitals,
  and more.
• There are many different ways to weed out
  potentially dangerous municipal bonds.
• You also want to make sure you never put
  municipal bonds in your Roth IRA.

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Corporate Bonds

• These are bonds issued by corporations,
  partnerships, limited liability companies, and
  other commercial enterprises.
• Corporate bonds often offer higher yields than
  other types of bonds but the tax code is not
  favorable to them.
• A successful investor might end up paying 40 to
  50 of his or her total interest income to
  Federal, state, and local governments in the form
  of taxes, making them far less attractive unless
  some sort of loophole or exemption can be
  utilized.
• For example, under the right circumstances,
  corporate bonds might be an attractive choice for
  acquisition within a SEP-IRA, especially when
  they can be acquired for much less than their
  intrinsic value due to mass liquidation in a
  market panic, such as the one that occurred in
  2009.

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Main Risks of Investing in Bonds

1. Credit Risk
2. Inflation Risk
3. Liquidity Risk
4. Reinvestment Risk

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Credit Risk

• Credit risk refers to the probability of not
  receiving your promised principal or interest at
  the contractually guaranteed time due to the
  issuer's inability or unwillingness to distribute
  it to you.
• Credit risk is frequently managed by sorting
  bonds into two broad groups - investment grade
  bonds and junk bonds.
• The absolute highest investment grade bond is a
  Triple AAA rated bond.
• Under almost all situations, the higher the
  bond's rating, the lower the chance of default,
  therefore the lower the interest rate the owner
  will receive as other investors are willing to
  pay a higher price for the bigger safety net as
  measured by financial ratios such as the number
  of times fixed obligations are covered by net
  earnings and cash flow or the interest coverage
  ratio.

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Inflation Risk

• There is always a chance that the government will
  enact policies, intentionally or unintentionally,
  that lead to widespread inflation.
• Unless you own a variable rate bond or the bond
  itself has some sort of built-in protection, a
  high rate of inflation can destroy your
  purchasing power as you may find yourself living
  in a world where prices for basic goods and
  services are far higher than you anticipated by
  the time you get your principal returned to you.

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Liquidity Risk

• Bonds can be far less liquid than most major blue
  chip stocks.
• This means that, once acquired, you may have a
  difficult time selling them at top dollar.
• his is one of the reasons it is almost always
  best to restrict the purchase of individual bonds
  for your portfolio to bonds you intend to hold
  until maturity.
• To provide a real-life illustration, I recently
  worked to help someone sell off some bonds for a
  major department store in the United States,
  which are scheduled to mature in 2027.
• The bonds were priced at 117.50 at the time. We
  made a call to the bond desk - you can't trade
  most bonds online - and they put out a bid
  request for us. The best anyone was willing to
  offer was 110.50.
• This person decided to hold the bonds rather than
  part with them but it's not unusual to encounter
  such a discrepancy between the quoted bond value
  at any given moment and what you can actually get
  for it a difference known as a bond spread,
  which can hurt investors if they aren't careful.

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Reinvestment Risk

• When you invest in a bond, you know that it's
  probably going to be sending you interest income
  regularly (some bonds, known as zero-coupon
  bonds, do not distribute interest income in the
  form of checks or direct deposit but, instead,
  are issued at a specifically-calculated discount
  to par and mature at their face value with the
  interest effectively being imputed during the
  holding period and paid out all at once when
  maturity arrives).
• There is a danger in this, though, in that you
  cannot predict ahead of time the precise rate at
  which you will be able to reinvest the money.
• If interest rates have dropped considerably,
  you'll have to put your fresh interest income to
  work in bonds yielding lower returns than you had
  been enjoying.

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