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What are bonds? How they work and terms to know

Bonds are a long-term investment for passive income. But if you’re seeking liquidity – or big returns – you might want to look elsewhere.

Bonds can be a decent investment option with steady income. But depending on the bonds, your return can be much lower than other investment options.

Bonds defined

Bonds are an asset class much like stocks, commodities and real estate. But unlike these three, bonds represent loans made by investors to borrowers. These borrowers are known as bond issuers and are often either government or corporate entities.

Aside from paying back the principal, the bond issuer also pays interest — which can be fixed or variable. This is known as the coupon. Because the bondholder earns interest, bonds are also known as fixed-income securities.

3 types of bonds

Bonds are designed to provide the bond issuer with funds for investments or expenditure. Depending on who issues the bond, there are three major types: corporate, government and municipal.

1. Corporate bonds

Companies may resort to traditional loans or bonds to get funds for investments or to cover day-to-day operations. Because bonds often come with lower interest rates and more favorable terms than traditional loans — companies may prefer to choose the bonds route.

But since companies may go bankrupt or fail to pay off their debt, corporate bonds can have a higher risk than US government bonds.

Tax implications: Corporate bonds are subject to both federal and state income tax.

2. Government bonds

As the name suggests, government bonds are issued by the government. In the US, that’s the Treasury Department.

Because of that, they are often referred to as “Treasuries” or sovereign debt. And since this type of bond is backed by the US government, they are considered one of the safest investments.

Depending on the length of the bond’s maturity, government bonds have different names. For example:

  • Bills are Treasuries with a maturity of one year or less.
  • Notes are Treasuries with a maturity of between one and 10 years.
  • Bonds are Treasuries with a maturity of 20 or 30 years.

Tax implications: Government bonds are subject to federal taxes but are often exempt from state and local taxes.

3. Municipal bonds

Municipal bonds, also known as “munis,” are issued by states, cities and counties, as well as government agencies. These are often used to fund local projects, such as schools, sewers and highways.

Tax implications: Interest income from municipal bonds is usually exempt from federal tax and may be exempt from state tax as well. However, capital gains are often taxed.

How bonds work

When a company or government entity needs money either for investments or day-to-day obligations, it can issue bonds. The bond issuer sets the terms, i.e. the bond’s face value, maturity date and interest rate.

The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount, say 5% annually, paid to the bondholder.

The face value is what the bond issuer will pay for each bond on the maturity date. It’s also the value on which the interest rate is calculated.

Here’s how that would work:

  1. Company X issues a bond with a face value of $1,000, a 2% interest rate and 10 years maturity. Because bonds are negotiable, meaning bond ownership can be transferred to the secondary market, the bond can be resold and bought again at a different price by other investors.
  2. If an investor bought the bond on the market at a discount, say $900, the bond issuer would pay back the face value of $1,000 when the bond reaches maturity, thus the investor earns an additional profit on top of the 2% annual interest rate.
  3. Suppose the same investor bought bonds for $9,000 in the second year after the interest was already paid, and held it until the maturity date. The investor would earn $2,716 in interest and in face value difference. That’s a total of around 30% earned in eight years.

For comparison, the same $9,000 investment in the S&P 500 index with an average annual return of 10% would earn $10,192 or 114% return on investment.

Bond market price and interest rates can change

Creditworthiness and date of maturity are often the two factors that determine the interest rate. If the bond issuer has a poor credit rating and the risk of default is high, the interest rate will be high as well. The opposite also applies — low-risk bonds, such as treasuries, pay low-interest rates.

The bond’s issuer credit quality also affects the market price on the secondary market, meaning quality bonds may cost more than the bond’s face value.

How to buy bonds

Everyone can buy bonds whether it be corporate or treasury bonds on the secondary markets or directly with the treasury.

Broker

Accessing the bond market via an online brokerage is one of the simplest and fastest ways to buy bonds. Here’s how:

  1. Find a broker that offers bonds — for example, IBKR.
  2. Open an account and fund it.
  3. Request access to trade bonds, if required.
  4. Look for the bonds you wish to purchase on the broker’s platform.
  5. Create a Buy order, which can go under the Ask name.

Exchange-traded fund (ETF)

ETFs are a simpler way to buy bonds. That’s because not every broker lets you buy bonds, but almost every broker allows you to buy ETFs. To buy ETF bonds, you need to:

  1. Have an account with an online broker.
  2. Find the ticker symbol of the bond ETF you want to buy.
  3. Enter the number of shares you want to buy.
  4. Review your order and submit.

Treasury Department

Buy government bonds with a minimum of $100 directly from the Treasury Department. This is a slightly more complex way to buy bonds than using the previous methods. Here’s how it works:

  1. Visit treasurydirect.gov and select Open an Account.
  2. Select the Go button next.
  3. Scroll down to the bottom of the page and select Apply Now.
  4. Select the type of account you want and fill in the required information.
  5. When you open an account, log in.
  6. Wait for an auction — you can find more information about upcoming auctions on the Treasury Direct website.
  7. Submit a bid during an auction.
  8. Pay for the bond.

Key terms to know

TermDefinition
Call featureA feature that allows the bond issuer to buy back bonds at a set price in the future. Not all bonds are callable.
CouponA coupon is the annual interest rate paid on the bond’s face value.
Coupon dateThis is the date when the bond issuer pays the interest rate to the bondholder, typically twice each year.
Credit qualityA measure of a company or government entity to pay its debt.
DefaultA bond default is when the bond issuer fails to pay the interest or the principal back to the bondholder within the specified period.
DiscountA discount is when the bond’s price on the market is lower than its face value.
Face valueThis is the bond’s value paid on the maturity date.
Investment gradeBonds with high ratings and low risk of default are called investment-grade bonds.
IssuerThe company or government entity that issues the bonds.
JunkA term used for high-risk bonds.
Maturity dateThe date when the bond issuer has to repay the principal back to the bondholder.
ParPar is the same as face value.
PremiumThis is when the bond is priced higher than its face value on the secondary markets.
PriceThe present market value of a bond, which may differ from the face value.
PrincipalThe amount of money the bond issuer has to pay to the bondholder on the maturity date.
YieldThis is the return an investor would earn on a bond investment.

Bond ratings

Bonds are assessed by bond rating agencies that take into account the issuer’s financial strength and its ability to pay back the principal and interest on time.

The most popular rating agencies are Moody’s, Standard and Poor’s, Fitch Ratings and DBRS. Each of these agencies has its own grades, but in general, bonds with an AAA rating are considered investment grade with low risk. On the other hand, bonds rated CCC are considered junk with a higher risk of default.

Where to find ratings

Finding bond ratings is simple no matter which agency you go with. For example, if you choose Fitch here’s how to find the ratings:

  1. Visit fitchratings.com.
  2. Select the search tab.
  3. Enter the company name or the country you wish to find.
  4. Make sure to use the company full name — eg. Ford Motor Company.
  5. Submit.

Advantages of bonds

Bonds may not be the first choice for growth investors because they often come with lower returns. But other investors may find the bond’s advantages appealing.

  • Steady income. Bonds’ interest rates provide investors with steady income each year.
  • Preserving capital. On the maturity date, the bond issuer pays back the entire principal to the bondholder. This can serve as a way to preserve capital.
  • Less volatile than stocks. Choosing the right bonds can help you avoid volatility.

Drawbacks of bonds

Despite its advantages, there are some risks to consider.

  • Bond issuers may default. The bond issuer may fail to pay the interest rates and the principal to bondholders.
  • Inflation. Rising inflation may eat up the bond’s interest rates value.
  • Low liquidity. Depending on the bonds, you may find it hard to sell them on the secondary markets.
  • Call risk. Some bonds are callable, meaning the bond issuer can buy them back before they reach maturity.

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Bottom line

As an asset class, bonds are worth considering for investors looking for low-risk, fixed-income options. But this only works for investment-grade bonds. Junk bonds may be good for those who want to make higher returns, but the risk of default is also high.

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