Understanding Bond Markets

What they mean for typical investors
Investing in bonds is different from investing in stocks. Stocks represent ownership in a company. This ownership is not one where you can tell management how to run the company but rather a relationship where you benefit if the stock's price rises, plus you receive any dividends paid by the company.

If stocks represent ownership, bonds represent "loanership."" Bondholders are loaning the company or the governmental entity money for a fixed period of time. At the end of that time period, bondholders receive the face amount of the bond back plus any interest paid on the bond during the period in which they own the bond. Most bonds issued by corporations have a $1,000 face value and pay interest semi-annually. Other arrangements exist as well. For example, there are zero-coupon Treasury bonds that pay no interest but sell at a discount to the $1,000 that bond holders will receive when the bonds mature. The interest is in the form of the difference between the discounted purchase price and the value paid to bondholders at maturity. For example, a 20 year zero coupon Treasury with an implicit 3% yield would sell for $553.68 and pay the bond holder $1,000 at the end of 20 years.

Inverse relationship with interest rates

The price of an individual bond moves inversely with interest rates. As interest rates move higher, the price of a bond will decline in order to offer a yield that is in line with the new higher interest rates. Bonds with a longer time to maturity will be more sensitive to interest rate moves all things being equal. This is due to the fact that more things can occur the longer the time until the bond matures. These "things" can include interest rate fluctuations, a change in the credit-worthiness of the bond issuer and a change in the economy among other things.

Bond ratings

Independent ratings agencies provide ratings for bonds based upon the credit-worthiness of the borrower. The U.S. Government has the highest AAA rating. The rating of other governmental units and agencies might be lower, however. The main concern of a bond buyer, whether an individual investor or an institutional buyer like a pension fund, is the ability of the bond issuer (borrower) to eventually pay back the face amount of the bond and to make the periodic interest payments spelled out in the bond indenture or contract. For bonds with a lower ranking, raising the money they need will be more expensive, usually in the form of a higher interest rate. The bond offering could include other terms as well that push their costs up.

Bond mutual funds and ETFs

There are numerous mutual funds and ETFs that invest in various types of bonds. There are both actively managed and passive index versions of both. As with stock funds and ETFs, the benefit of using a managed account is that you receive professional management and a degree of instant diversification across a number of different bond holdings. Bond funds and ETFs can be both actively managed as well as passively managed index products. Generally, actively managed bond funds and ETFs will carry a higher expense ratio than their passively managed index counterparts.

Types of bonds

There are any number of different types of bonds: Government bonds The U.S. Treasury issues a variety of bonds with maturities ranging from the very short-term (known as Treasury Bills or T-Bills) to intermediate and long-term bonds. The rates on Treasuries are often quoted in the financial press and are a benchmark of sorts for investors. Municipal bonds These are bonds issued primarily by state and local governments. These can be to raise money for the issuer in general, or tied to a specific project or entity. Some of these bonds are backed by specific revenues the municipality expects to earn and this is often considered a margin of safety for bondholders. The main advantage of "munis" is that the interest earned is not subject to federal taxes. This can make these bonds attractive to investors in higher income brackets. They are, of course, not an appropriate investment for a tax-deferred retirement account like an IRA. Corporate bonds These bonds are issued by corporations and are a legal obligation of the company. Corporates will generally offer a higher rate of interest than government bonds as they can be subject to the risk of default unlike the government. These bonds usually have value of $1,000 and pay interest semi-annually. They may have a call provision which allows the company to call or redeem the bonds early if they feel market conditions warrant. Some issues use convertible bonds which allow the holder to convert the bonds into a specified number of the company's shares of stock. Foreign bonds Just as in the U.S., foreign governments and corporations issue bonds to raise money. In addition to any ratings for creditworthiness, U.S. investors need to be concerned about currency fluctuations relative to the U.S. dollar.

Bonds for individual investors

Individuals can buy bonds through their advisor or typically wherever they house their other investments. Buying individual bonds may entail a transaction fee, but will also be subject to a spread. This is the difference between what the advisor paid for the bond and the price that they will sell them to you for. For many individuals it is more efficient to purchase bond mutual funds or ETFs. You get the benefit of professional management and you do not have to do the research and due diligence on individual issues.

Bonds and rising interest rates

As mentioned previously, rising interest rates will cause the price of individual bonds to drop. With individual bonds this is not an issue if the bonds are held until maturity, although there may be some opportunity costs. Bond funds and ETFs never mature so investors do need to do their homework to determine how much a given fund will be impacted.

Summary

Investing in bonds is often misunderstood by many investors. Bond investors are loaning the bond issuer money for a fixed period of time and in return expect to receive the face value of the bond upon maturity and period interest payments. Just as with individual stocks, many investors may be better off investing in bond mutual funds and ETFs. They have the benefit of professional management and a level of diversification among a number of issues.

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