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How Do Bonds Work?

Bonds are one of the building blocks of our marketplace. Understand how bonds work and how you can identify a quality bond to invest in.
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When we talk about investing, bonds inevitably come to mind. Bonds can be lucrative and relatively safe investments if purchased under the proper conditions. However, before you begin investing in bonds, you first need to understand how bonds work and their role in the marketplace.

How Does a Bond Work?

When you purchase a bond, you are essentially loaning funds to a business, municipal entity, or government entity. All of these entities often need to borrow large amounts of money to make changes that will allow them to be more profitable or effective in the long term. Unfortunately, banks are often unable to provide loans of the size that many of these entities need. Bonds help fill this void.

Bonds typically come in the form of a certificate. When you buy a bond, the entity you purchase it from promises to pay you interest during the length of the loan. In the case of bonds, the interest rate is called the "coupon rate." While bond terms will vary, the most common terms for corporate bonds is to pay out interest semiannually. Typically, the longer the length of the loan, the higher the coupon rate. However, the terms of each bond will vary. If you are considering any bond purchase, it is important to understand exactly how much and how frequently you will get paid out.

So when does your investment fully pay off? The entity you purchased the bond from will pay the principle of the loan when the bond reaches its date of maturity. Bond maturity dates run the gamut, ranging from a length of one month to up to 50 years.

How Do You Know the Value of a Bond?

Determining a bond's value is surprisingly complicated. Despite being a generally safer investment, the value of a bond is dynamic and can change over time. Find out what factors are taken into account when evaluating a bond's value.

Original Value

As one might expect, the amount that the bond was purchased for contributes to the bond's overall value. Since an investor can expect to get their principle amount returned on the bond's maturity date, this is part of calculating a bond's overall value.

Interest Rates

A bond's value is greatly intertwined with market interest rates. In fact, interest rate risk is the single most important factor for understanding the true value of a bond and how it will be evaluated in the marketplace. The main benefit of a bond isn't just the interest payments, but also the interest rate of the bond compared to the current market. For example, if you put $1,000 into a bond with a 5% interest rate, you will get a greater return on your investment than putting that $1,000 into a savings account with a 2% interest rate. Because of this, when interest rates climb, the value of the bond declines because the money could be better invested elsewhere. When interest rates drop, the value of the bond increases because it provides a greater return than other forms of savings or investment.

Maturity Date

The other way to determine a bond's value is by evaluating its maturity date. When an investor purchases a bond, they are not only getting returns through interest payments, but will also get the bond's principal returned on the date of maturity. The closer a bond is to its maturity date, the greater its worth will be when trading.

Are Bonds Ever Risky?

Generally speaking, bonds are less risky than some other types of investments. Unlike stocks, which offer returns based on the profitability of business you purchased it from, bonds allow you to receive returns at a fixed rate (most of the time). However, there are some dimensions to consider when evaluating a bond's risk.

1. The Bond Issuer

If an investor considers purchasing a bond, the best measure of risk is the entity issuing the bond. Putting money behind a low-yielding bond issued by a company that is a high risk of defaulting would generally be considered a risky investment. Before purchasing a bond, it is important to understand the issuer's financial position, ranging from their debt levels to their business plan. You can also do this by working with a financial organization that can research and evaluate the risk to determine a bond's rating. These ratings are often used to determine the risk level of investing in a specific bond.

2. Interest Rate Fluctuation

While many bonds have a fixed interest rate, floating-rate bonds have flexible interest rates that can increase or decrease based on current market conditions. This can be a positive or negative for the investor, depending on market conditions. If interest rates are high, then the investor will receive greater returns through interest payments. Unlike a fixed-rate bond, the investor is unable to predict their income stream on a consistent basis with a floating-rate bond. Floating-rate bonds can be a solid investment if current interest rates are expected to rise or if the investor would like to maintain a portfolio that can weather inflation.

3. Bond Security

Purchasing a secured bond is generally considered a less risky option for investing, but this generalization leans on the issuer of the bond. Secured bonds are collateralized, meaning that they have some form of physical asset behind them in the event of a default. For example, if a municipality issues a bond for an upcoming public works project, the investor will have claim to a portion of the land they were working on for the project.

Unsecured bonds are backed by promises alone, meaning that if the issuer bond defaults, the investor has no claim to any specific collateral. However, this doesn't necessarily mean that the investor will never get their money back in the event of a default. Instead, they may be paid out after investors with secured bonds.

The significance of bond security is limited compared to the entity who is issuing a bond. For example, an unsecured bond issued by the U.S. Treasury is generally considered a sound investment, as the government has a two-century history of timely interest and principal payments.

Is a Bond a Loan?

In the simplest terms, a bond is a loan. However, the true answer to this question is more complex. From the bond issuer's point of view, bonds can be advantageous over loans as they typically offer lower, fixed interest rates that would be more difficult to obtain from a normal bank loan. Additionally, bank loans typically come with restrictions around operations and acquisitions, while bonds allow the issuer to act as they wish. Unlike a loan, a bond is tradeable and can be exchanged between owners within a marketplace. This is not the case with a loan, which typically involves a set agreement between a bank and the entity requesting the loan.