What is a Bond?
Bonds, which are a unit of debt are often referred to as fixed income securities. When a government or corporation need to raise money (for whatever reason) and do not want to, or cannot take a loan from a bank they can borrow that money from investors by issuing a bond.
For example, company A wants to raise $100 million to fund research and development but do not want to borrow that money from the bank. Instead, they choose to issue $100 million worth of bonds which are purchased by investors. Company A now owes these investors the$100 million + the prescribed interest rate.
Common Bond Terminology
“Shaken not stirred”… Okay last “Bond Pun”, I promise.
One thing I do hate about finance is the terminology. The world of Bonds has its own quirky terminology, let’s break down some of the common terms as it relates to Bonds (I will resist the urge to tell you an “oo” agent is an agent with a license to kill”.)
Face Value is the amount of money the bond will be worth at the Maturity Date
Maturity Date Is the date that the bond issuer repays the bondholder (the person who bought the bond) the Face Value of the bond.
Coupon Rate is the interest rate the bond pays each year, based on the face value. For example, if the bond has a $100 face value and a Coupon Rate of 6% the bond issuer must pay the bondholder $6 (6% of $100) each year until the Maturity Date
Coupon Date Is the date on which interest is paid
Issue Price Is the original selling price of the bond
Bonds Inverse Relationship to Interest Rates
Interest rates and bond prices have an inverse relationship, meaning when interest rates rise the price of bonds fall and vise-versa. Why might this be? An important feature to remember about bonds is that their coupon (interest) rate is fixed. This means if you agree to a 5% coupon rate when you buy a bond, that coupon rate remains at 5% until the maturity date, which could be years away. If you agree to a 5 year bond at a coupon rate of 5% you receive 5% per year for 5 years, whether interest rates in the market jump to 10% or fall to 1% you receive 5% for 5 years.
Lets illustrate the impact of interest rates on bond prices using 2 example, when rates rise and when rates fall.
When Interest Rates Rise
Let’s say you bought a $100 bond with a coupon rate of 5%, which means you receive $5 in interest each year. A year later interest rates rise so that the same $100 bond has a coupon rate of 6%. If you wanted to sell your current bond, you would have to sell it at a discount (less than the $100 you paid for it). Why? Because no one would want to buy a $100 bond with a 5% coupon rate when they can buy a $100 bond with a 6% coupon rate, remember your 5% coupon rate is locked in.
That is why when interest rates rise, bond prices fall.
When Interest Rates Fall
The opposite is true when interest rates rise. Use the same $100–5% coupon rate bond in the previous example, only this time interest rates a year later fall to 4%. Now your bond paying out 5% looks pretty darn good when other bonds are only paying out 4%. This would give you the ability to sell your bond at a premium.
That is why when interest rates fall, bond prices rise.
Bonds as a Hedge Against Stocks
While you can still lose money investing in bonds, they are traditionally seen as much less volatile than stocks and have traditionally been used as a hedge against a downturn in the stock market. According to Blackrock, in the 24 years where the U.S stock markets have experienced negative return, U.S. 10-year Treasuries had positive returns in all but three of those years. The theory being, if you have a decent amount of your portfolio invested in bonds (in addition to stocks) when the stock market produces a negative return, in theory the portion of your portfolio invested in bonds could still have a positive return, protecting you from some of the downside of stock market declines. That's why it is considered a “hedge” against the stock market.
Watch out for Inflation!
While many believe that odd-job or Jaws is a Bond’s worst enemy (Sorry could not resist one more James Bond joke), in fact it is inflation. Inflation has both a direct and an indirect impact on bonds.
Direct Impact: Remember we just mentioned that your interest rate payments on a bond are “locked in”? What happens if you have a 5% interest rate, and inflation rises to 5% per year over the term of your bond? What happens is your “real” interest payments will be 0% each year, as your 5% interest payments are completely wiped out by the fact that the cost of living has increased by 5% as well.
Indirect Impact: Typically, when inflation rises faster than expected central banks will raise interest rates to make borrowing more expensive and cool down the economy and thus keeping inflation under control. Remember that bond prices and interest rates have an inverse relationship. So faster than expected inflation can lead to interest rates rising which can lead to the price of bonds falling.
Bottom line, inflation is definitely something bond investors will want to think about if they are investing long term.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
