What are bonds?
A bond is an investment that represents an obligation to repay borrowed funds. Money is loaned by an investor to a borrower — usually a company or government. Those are the most common types of bonds, with the majority being government issued. Governments are stable and can raise taxes to cover debt payments, so government bonds are almost always higher quality, but there are exceptions.
The investor or lender receives interest in exchange for loaning their money. Bondholders do not have ownership rights, as is the case with stocks. They do rank higher in the capital structure though, which means they would get paid before shareholders, in the event of insolvency.
While the face value of a bond doesn’t change, the market value or price does change over time. Bond prices are affected primarily by interest rates, the level of inflation, and credit ratings. Bonds receive a letter grade that reflects the quality of that issue and creditworthiness of the issuer, with the three main credit rating agencies being S&P, Moody’s and Fitch. Ratings can change too, which would affect pricing.
Unlike stock investments, bonds can vary significantly based on the terms of their indenture, which is a legal document that outlines the specific features of that bond. Every bond issue is different, so it is extremely important that investors understand these terms.
Bonds and bond funds
Investors can own individual bonds or gain exposure to bonds through mutual funds and ETFs that invest in them. Minimum investments for individual bonds are high, but investors can access a suite of attractive bonds with a much smaller investment in a bond mutual fund or fixed income ETF. With funds and ETFs, investors own a pro-rata share of all the individual bonds held in that commingled vehicle.
Learn the lingo
Bond terminology is confusing to most people. These are some important terms that investors should know and understand.
Coupon: The interest rate paid on the bond, which is usually set in advance. Coupon interest payments are quoted as an annual rate with payments made semi-annually.
Face value: The amount a bond is worth at issue — also known as “par” value — for most bonds the face value is set at $1,000.
Maturity: The date by which the issuer or borrower must repay the original bond value to bondholders and usually classified as follows:
- Short-term: Matures in 1-3 years
- Medium-term: Matures in 3-10 years
- Long-term: Matures in 10-30 years
Price: What it would cost to acquire the bond on the secondary market and quoted as a percentage of face value. Several factors affect a bond’s price, but one of the biggest is how favourable its coupon is compared to other similar bonds.
Yield: A measure of interest that takes into account a bond’s fluctuating value. Bond yields are used as a measure of return. There are different ways to measure yield, but the simplest is the coupon divided by the current price.
Why invest in bonds?
Investors view bonds as a means to earn interest income and add some stability to their portfolio. This is because bond prices fluctuate less than stock prices and can be influenced by different factors or differently by the same ones, versus equities. Adding bonds enables investors to diversify.
Bond investors won’t feel as much pain when a company isn’t doing so well or the markets are down, but nor will they directly benefit from a company’s growth. This enhanced stability can be of considerable importance, especially during turbulent equity market periods.
Over a long-term investment horizon, this allocation to bonds is often referred to as the part of the portfolio that lets investors sleep at night.
It’s also what sometimes helps them to stay invested – which is important, because the best way to reap the rewards from the good times in the market is to remain invested and stick to a plan that makes sense for you.