Understanding bonds and things like why they behave the way they do if interest rates rise or fall is really not that hard if you know some of the basic facts. Today we'll go into what bonds are and why they behave the way they do.
What is a bond? A bond is a loan that is made to an entity, typically a government or a corporation. Unlike a consumer loan such as a mortgage, however, the government or company doesn't pay down the loan as they go. Instead, they pay interest only throughout the life of the loan, and then pay back the loan in full on a future date.
What is a coupon? The coupon is the percentage interest the bond will pay throughout its life if you bought it from the entity directly. For example, if a bond has a coupon of 6.75, it would pay 6 3/4 percent interest each year on your initial investment.
When do bonds pay back the loan? Bonds have a maturity date, which is when the company or government will pay back the loan. For example, an AT&T 20 8.75 bond would mature in 2020 and pay 8 3/4 percent interest until then. When it matured in 2020, it would pay back the loan amount, which is typically $1,000 per corporate bond.
Why do bonds sometimes pay more or less interest than the coupon? A bond pays a fixed amount of money on a periodic basis, typically every six months. The amount of money paid out does not change, but the price of the bond can change. For example, an AT&T 20 5.00 bond would pay $50 per year, or $25 every six months. The person who bought the bond from AT&T would have paid $1,000 for the bond, so he would be getting 5% on his money each year. If someone else bought the bond from him for $500, however, the second person would still be collecting $50 per year, but that would be equivalent to a 10% interest rate for the amount the second person paid for the bond. To make things even better, when the bond matured, the person who paid $500 for the bond would get $1,000 from AT&T, effectively getting an even higher interest rate on his $500 investment. This is one reason you typically want to pay less than the full price for bonds.
Why do bond interest rates go up when the price goes down and vice versa? Because the amount a bond pays is fixed, if you pay more for it, you're getting a lower interest rate. If you pay less for it, you're getting a higher interest rate. Often people report on the yield of a bond rather than reporting on the price. If they say that yields are going up, it means that the price of bonds is going down.
Why do bond prices go down when interest rates go up? If interest rates are rising, typically because the Federal Reserve is raising interest rates or people are scared of inflation, bond prices will fall. This is because there is always a relatively fixed spread between the interest rate bonds pay and those that other investments like bank CDs pay. If bank CDs are paying 2% interest, relatively secure bonds may be paying 6% interest. If bank CDs start paying 5%, bonds might go down in price until people buying them are getting 9%. New bonds issued at this point would also need to offer about a 9% coupon or no one would buy them. The reason is that there is risk in buying bonds that there is not in CDs. You pretty much know how much your CD will be worth in a year or two. You do not know what the price of a bond will be until the bond matures. The company may also default on the loan, making your bonds worthless, so people will not buy bonds unless the amount of extra interest they get beyond what they could get from a CD is high enough.
Can you lose money in bonds? Absolutely. The worst losses come when a company goes bankrupt. Then, you'll be lucky to get $25 back for a bond you paid $1,000 for. You can also lose money if you buy bonds and then interest rates rise. For example, in the last year or so bond mutual fund investors have lost 8% since interest rates have been rising. People buying now could see an 8% gain in the price of the bonds if interest rates went back down to where they were.
Are bonds safer than stocks? Yes, and no. If you buy a whole bunch of different bonds, or buy a bond mutual fund, you'll see less severe changes in your portfolio than you'll see if you buy all stocks. This is because 1) eventually the bonds will mature and repay the loans, so on average you'll get your money back if you wait long enough and 2) as bond prices go down, the interest rate they pay goes up, so eventually people will come in and buy and support the price just because they can get such a great interest rate. When you buy individual bonds, however, ou're making a loan to a specific company. If that company goes bankrupt, you'll lose all of your money. This is about the same thing that happens to the stock when a company goes bankrupt.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
