INVESTING • READ TIME: 6 MIN
"The phrase 'perception is reality' is overused generally. But perception can be reality in monetary policy.
The bond market doesn't merely act on what it sees. It acts on what it expects of the Fed or the government."
Amity Shlaes
What is a Bond?
Regardless of the type of bond (and there are many), bonds are fixed-income securities that represent a loan from an investor to a government or corporation. Bond issuers may use the borrowed money to fund projects operations, or pay down other debts. The investor, depending on the type of bond, receives interest on the investment leading up to a final principal payment at a pre-determined date. Bonds may be bought and sold in secondary markets, so their market price (like equities) can fluctuate over time.
As outlined previously, bonds are one of three – equities, fixed-income, cash – asset classes that are typically incorporated into an investment portfolio to diversify and/or decrease overall portfolio risk. Historically, bonds and stocks are inverse securities. This means the market price of equities and bonds will typically move in opposite directions - they are negatively correlated.
Basic Bond-Related Terminology
There are three main components used to determine a bond’s yield: the principal (face value), the coupon rate, and the maturity date. To establish common verbiage, these terms are outlined below:
- A bond’s principal denotes the amount of money the issuer will pay to the lender at expiration. The principal amount is typically listed in $100, $1,000, or $10,000 increments, but the actual market value may fluctuate in the secondary market (which is how bonds trade at a “discount” or “premium” during their lifetime).
- The coupon rate is the percentage of the principal paid back to the investor as interest. For example, a bond with a face value of $1,000 paying 5% means the investor will receive $50 in interest per year (in most cases, this will be paid semi-annually as $25 per payment).
- The maturity date is the date when the principal must be paid back to the bondholder. The bond issuer will make interest payments while holding onto the investor’s money, and then (at maturity) the issuer will also pay back the principal of the bond.
Another significant element to be aware of the in the fixed-income realm is the impact of credit ratings. Credit ratings play a prominent role in the pricing, “risk level,” and interest rate of a bond. Bonds are rated by agencies such as Moody’s and Standard & Poor’s. The higher the rating, the lower the risk that the borrower will default on the loan. US government bonds are typically considered the safest investment, followed by municipal and corporate bonds.
The Three Main Types of Bonds
(1) US Treasury Securities
The United States Treasury offers three types of securities: Bills (“T-Bills”), Notes (“T-Notes”), and Bonds (“T-Bonds). Because these securities are issued by the federal government, they are considered to be low risk. In return for being backed by “the full faith and credit” of the United States government, the yield on these securities will generally be lower than that of corporate bonds. Treasury securities are not federally tax-exempt, but they are exempt from state and local tax.
Treasury Bills
T-Bills are short-term securities that are non-interest bearing (zero-coupon) with maturities as short as a few days or up to 52 weeks (with varying maturities in between). Treasury Bills are purchased at a discount, and then repaid in full (face value) at maturity. For example, an investor may purchase a 52-week $1,000 T-Bill for $950 – meaning, at the end of 52 weeks, the investor will receive $1,000 for holding the Bill to maturity.
Treasury Notes
Treasury Notes are fixed-principal securities with maturities between two and ten years. Interest on T-Notes is paid semiannually, with the principal paid when the note matures. As is also the case with Treasury Bonds (below), Notes with longer durations (time until the bond matures) are more sensitive to interest rate changes. For example, a Note that matures in ten years will fluctuate more in value due to interest rate changes than a Note maturing in two years.
Treasury Bonds
Treasury Bonds are long-term, fixed-principal securities issued with 20 or 30-year maturities. Outstanding fixed-principal bonds have terms from 10 to 30 years. Interest is paid on a semiannual basis with the principal paid when the bond matures. Both Treasury Bonds and Notes are sold in multiples of $100.
Click here to visit Treasury Direct - the United States Treasury Department's website for buying, selling, and researching government bonds.
(2) Municipal Bonds
Municipal bonds are issued by local (a cities, towns, counties) and state governments to fund public projects, like infrastructure, parks, or hospitals. Investing in municipal bonds means you don’t have to pay taxes on the interest you earn. Like any other type of bond, investors who purchase a municipal bond are loaning money to the issuer in exchange for a specified number of interest payments until maturity. Because municipal bonds are tax exempt, they are most often found in the portfolios of investors in higher income tax brackets1.
There are two distinct types of municipal bonds (“munis”): general obligation (GO) bonds and revenue bonds. General obligations bonds are not backed by any assets owned by the city, county, or state. Instead, they are backed by the taxing power of the issuer. Revenue bonds are also backed by a municipality’s taxing power, but primarily generate revenue from a specific source (highway or bridge tolls, local stadiums, etc.)
Click here to visit Electronic Municipal Market Access (EMMA) - the MSRB's site for researching municipal securities' documents and data.
(3) Corporate Bonds
Corporations may issue bonds in order to raise capital for purposes such as research or development. If a company is publicly listed, then issuing bonds is similar to the issue of new shares. They are both ways for corporations to raise capital. Corporate bonds are generally backed by the ability of the company to repay the loan, which depend upon future revenue and profitability. Companies may also use physical assets as collateral to “back” the bonds they issue.
Corporate bonds, in general, are considered to be riskier than US government securities (although high-quality corporate bonds from “blue-chip” companies are considered relatively safe investments). Therefore, yields are typically higher on corporate bonds. Unlike Treasury and municipal bonds, interest earned from corporate bonds are typically taxed at state and federal levels.
Payments from Individual Bonds and/or Bond Funds
Now, with a basic understand of the different types of bonds and terms associated with them, we can examine the specific ways in which investors may profit or generate income from these investments. There are a number of ways in which investors may seek to profit from direct or indirect ownership of bonds:
- An investor buys bonds directly, with the intention to hold the security until maturity. This allows the investor to generate income from interest payments. In the case of coupon-paying bonds, an investor receives interest payments for the life of the bond using the interest rate printed on the bond at the time of issue.
- Similar to purchasing individual bonds, an investor may purchase bond funds (mutual funds, ETFs) in order to generate income from interest payments. The fund managers will purchase bonds and distribute income in line with the fund's stated objectives.
- An investor buys bonds or bond funds with the intention of profiting on the (market value) appreciation of said security by selling the bond in the secondary market prior to maturity.
- An investor may purchase zero-coupon bonds and receive no payments for the loan until their bond matures. A zero-coupon bond, like Treasury Bills, is often sold at a discount (below par). When the bond matures, the investor is paid the face value of the bond. Another name for zero-coupon bonds is "discount bonds."
Benefits & Risks Associated with Bonds
The Benefits of Bonds/Fixed-Income Securities
The fundamental difference between bonds and stocks can be summarized as: debt versus equity.
A bond represents debt, whereas stocks represent equity ownership. For this reason, bond investments are typically considered safer than investing in equity. This is due to the fact that debt-holders have priority claims in a company’s liquidation process (in the case of corporate bonds). In the case of US government bonds, the securities are backed by the faith and power of the federal government – which is why they are typically referred to as “risk-free assets.”
As a part of your investment portfolio, bonds with high credit ratings are likely to preserve capital and may (depending on the security) provide a steady income stream via interest payments. Additionally, bonds do not typically move in tandem with equities. Meaning, they have the ability to cushion your portfolio from large market downswings.
Owning individual bonds or bond funds in a portfolio can provide stability of cash flow and offset the volatility of equity positions. Used appropriately, bonds (government, municipal, and/or corporate) can and should be a consideration in building a balanced investment portfolio.
The Risks Related to Bonds/Fixed-Income Securities
Although there are benefits to owning bonds – protection of principal, predictable income streams, portfolio hedging, tax-efficiency – there are bond-specific risks to be aware of. Bonds are subject to, among others, interest rate (yield curve) risk, inflation risk, call and prepayment risk, reinvestment risk, credit (default) risk, liquidity risk, volatility risk, and sovereign risk.
One of the most significant risks associated with bonds is interest rate risk. Presently, government bond (due to current interest rates) yields are at (historical) all-time lows. With low bond yields, any increases in inflation may put bond investors in a "guaranteed loss" scenario - meaning, interest earned and principal repayment do not exceed the inflation rate. For this reason, many investors have recently sought higher yields in corporate bonds. Although corporate bonds or other "high-yield" bonds may offer better yields, there is an increased element of risk (which, ironically, is what most investors try to avoid through bond investments).
Bond prices are sensitive to the credit rating of the issuer. If credit rating agencies upgrade or downgrade the credit rating of the issuer, the bond price will impacted. An unanticipated downgrade will often cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond’s interest payments (assuming the issuer does not default), but puts at risk the market price. This change impacts funds (mutual funds, ETFs) holding these bonds, and holders of individual bonds who may want to sell them.
Finally, many investors make use of bond funds in order to diversify their portfolio. Bond mutual funds are just like stock mutual funds in that you pool your money with other investors. Then, the fund manager(s) invests that money at their discretion, in accordance with the fund’s investment goals. Oftentimes, these funds are more volatile than individual bonds because they do not have a fixed price or interest rate. Bond funds (mutual, ETF) represent pooled ownership of bonds with a constant "refreshing" of maturities, etc. as opposed to owning a particular bond with a fixed interest rate and duration.
Incorporating Bonds into Your Portfolio
As is the case with any investment portfolio, a careful consideration of the investor’s risk tolerance, time horizon, liquidity needs, and personal preferences is essential in determining the appropriateness of any given investment.
Investors building balanced portfolios often utilize bonds in order to offset riskier investments such as growth stocks. Bonds can provide a predictable source of income which may be attractive to investors in or nearing retirement. In general, investors increase their portfolio’s allocation to bonds as they get older in order to decrease portfolio volatility and safeguard accumulated capital. There are advantages and disadvantages to fixed-income investments, like any other security, but they are typically (in one form or another) an essential facet of a diversified portfolio.
1. Municipal bonds are generally tax-free. However, investors should determine a bond's tax consequences before investing. If an investor purchases a bond issued by an agency of their home state, there is (typically) no state tax charged. If an investor purchases the bonds of another state, their home state may tax the interest income earned from the bond.
The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.