Unlike the rollercoaster ride of stocks, bonds are slow and deliberate, like a Ferris wheel that takes a while to get going. However, once you reach the top, the view is breathtaking.
This article outlines the basics of bonds and answers some frequently asked questions about it in simple terms. Let’s get started!
What are bonds?
A “bond” is a general term that refers to a contract between a borrower (also called an issuer) and a lender (also called a buyer). Think of it as a fancier version of an “IOU” note that you gave to your grandmother when you asked her for some money – payable with interest upon a specified date – to buy candy. The bond contract is fulfilled when you give granny back the initial amount (also called the principal) together with the interest, or when she completely forgets about the entire deal, as grandmothers often do.
Unlike an IOU note, however, a bond contract is composed of reams of paper upon which certain stipulations are made to protect both parties. These terms are called restrictive covenants and can include the following:
- Certain rules that the issuer must abide by in order to manage potential risk and decrease the chances of him defaulting (not paying) on the loan and/or its interest due to bankruptcy. For example, there could be a requirement that states that the issuer must set aside reserved cash so that a portion of the principal could still be paid even in the case of financial duress.
- Specific conditions that strengthen the borrower’s ability to fulfill his obligations by putting clear limits on what financial decisions he can and cannot do. For example, some bond contracts specify that the borrower is not allowed to accumulate debt outside a certain amount.
These terms and conditions are often long and hard to read. The good news is that bond contracts are usually standardized and follow general guidelines, so it’s not necessary to go through everything with a fine-toothed comb. The things you need to focus on are bond issuers, interest rates, and maturity dates, all of which are answered next.
Who issues bonds?
Bonds are usually issued by countries, corporations and individuals. On the individual spectrum, it amounts to two people going into a bond contract, similar to the IOU example given earlier albeit on a more professional and legally-binding level. However, the reliability of person-to-person bonds is extremely low, and the chance of getting scammed is extremely high. Corporate bonds are those issued by organizations. They have less probability of defaulting on the payment compared to individuals, but the risk is still moderate.
By far the most popular bonds are government bonds (called treasuries if you live in the United States and gilts if you live in Britain). This type of bond is also the most recommended, since countries rarely go bankrupt or default on their loans, unlike companies and individuals. When the coffers are running low, the government can always raise taxes to pay off their debts. In this manner, you are practically guaranteed that your principal loan and the corresponding interest will be returned.
When do I receive payment and how much is the interest?
Bonds are extremely flexible, which means that payment of the loan and its interest can be made as early as a day or as late as a hundred years after the contract was made. Usually, the time period until payment is received (called the maturity) is between one to twenty years depending on the bond contract. Also, the varying maturity dates make it possible to implement an investment strategy called bond laddering, which will be discussed in a future post.
The amount of interest you will receive is also variable and will depend on the bond contract. Generally, the longer the maturity date and the larger the principal, the higher the interest rate. Interest rates usually hover around 5 to 10%, although it is not uncommon to find bonds that go up to 20% or more.
Some bonds deliver both the principal amount and the interest in one lump-sum payment on the maturity date itself. These types of bonds are called zero-coupon bonds (a coupon is a term that refers to the partial payment(s) of the interest before the maturity date). Other types of bonds pay back small portions of the loan in regular intervals leading up to the maturity date. In general, a standard bond usually pays interest every six months, and returns the principal amount on the maturity date.
What are some other considerations?
Another thing to be aware of is that a bond can be secured or unsecured. A secured bond is one in which the issuer sets aside some collateral that acts as a substitute payment to be given to the buyer in the event of bankruptcy or default. Collateral can include assets such as land, precious metals, buildings, or any type of property comparable in price to the bond principal. In the event of the issuer defaulting on payment, the buyer is immediately awarded the asset.
On the other hand, an unsecured bond does not have any safety net. In the event of bankruptcy or default, the buyer often has to go through a lengthy and time-consuming process to figure out what kind of compensation he (and the other bond holders) receives. Obviously, the secured bond is preferable.
What are the advantages and disadvantages of bonds?
The pros of bond investing are as follows:
- Generally secure in which the chances of the issuer going bankrupt and defaulting on payment is lower compared to stocks.
- Vast amount of information available online about the true market prices of bonds so that the chances of overpaying or getting conned is slim.
- Can be bought from a broker but can also be purchased directly from companies and corporations if you want to avoid paying a commission.
- Varying maturity dates and interest rates provide you with a wide range of choices depending on your financial goals.
The cons of bond investing are as follows:
- Generally more expensive to purchase than stocks or mutual funds. Oftentimes, the minimum lot size is worth $10,000.
- The money invested in a bond is locked-in until its maturity date. If an emergency need arises and you are short on cash, getting the money out of a bond quickly is difficult and often entails penalties on your part.
- Highly susceptible to inflation. If inflation rates rise, the value and purchasing power of your investment falls dramatically.
What are some strategies to effectively utilize bonds?
A sound strategy is called bond laddering. This mitigates the inflation and liquidity risks mentioned above by buying bonds at varying maturity dates. Bond laddering will be discussed in more detail in a future post on this website.
Ok, I’m convinced. Where can I buy bonds?
As mentioned above, bonds can be bought directly from the companies or individuals themselves, which they will often advertise on print and online media. You can also buy bonds through a registered broker in your country. If you are living in the United States, check out Treasury Direct which will allow you to purchase US treasury bonds online as well as other savings bonds. Other countries often have a similar website.
Look forward to future posts or browse through the blog archives for more investment strategies.