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What and how do bonds work?

 

Bonds for beginners:

 

Fundamentals:

Bonds are a debt owed to you (the bond holder). If a company (or government) needs more cash they can issue bonds. You give them money, they promise to pay you back at a given interest rate. Bonds pay a fixed interest rate to maturity, so if the company is still in business the bond will pay out.

 

Bonds do not lose value, but have low return rates (sometimes not greater than inflation), and can be somewhat difficult to add directly to your account.

 

Risks:

Bonds are a loan to a company from you. Think of your credit card, you own someone money in the future in exchange for use of the funds today. Bonds are the same thing, only a company owes you money at a specified rate in the future. Unless the issuer of a bond goes out of business/bankrupt/ceases to exist, you will be repaid.

 

Rates:

Bonds are more stable than stocks, so they typically have lower interest rates (low rate = lower risk). There is the possibility that inflation will become greater than the yield of a bond, resulting in a loss of buying power for this investment.

 

For example, US Treasury bonds are some of the safest securities, they are almost guaranteed to be paid unless the US ceases to exist, therefore these have a high demand and the treasury can offer low interest rates.

The US offers 0.692% on two-year bonds (as of 06/30/2015); Corporate BBB bonds offer a high of 2.48% for two years at the same time. Again, the difference is because corporate bonds (BBB) are more risky and therefore need a higher rate to attract buyers (if a company goes out of business, the bond will not be repaid).

 

Purchase:

US Treasury bonds (the safest bonds available) are somewhat easy to get: simply open an account at the US Treasury and you can buy a bond directly from the government (Treasury bonds only). You can buy these in multiples of $100 and it is also possible to trade these bonds on the market from current bond holders but this can be somewhat complex.

 

Getting other bonds depends on your broker or available funds. Municipal bonds are typically bought in amounts of $5,000 – if you have this much you can buy entire blocks.  This is possible through some Online brokers or professional brokers. If you want municipal bonds a good source is the State of California Website to get started.

 

Exchange Traded Funds (ETFs) for Bonds:

You can also buy bonds via ETFs, these are not exactly the same as buying a bond. It is very easy to trade Bond ETFs and simple to purchase, but there are drawbacks. If you want a quick refresher on what ETFs are and how they work check out our quick ETF guide here. Basically, if you buy a Bond ETF you are buying bonds traded on the stock market:

  •  The fund holds the bonds, you buy these like a stock
  •  The price of the fund changes based on the value of the bonds
  •  The funds return comparable income to what the bonds would yield (paid as dividends)
  • The ETF may trade for a lower price, making it look like a loss on principle

The catch is the fund value is not constant, because the value is based on the components of the fund as well as the market, the value of the fund will change, thus making it possible to lose or gain a small amount of value with these securities. This is counterintuitive: the fund owns bonds so the fund should not lose value, but bonds can loose market value even though the bonds do not loose value. This means the price of a bond ETF can decrease (even though bonds themseves do not decrese) and can result in losses. Overall, these funds are very stable compared to stocks, just look at the Vanguard Total Stock Market ETF for and example. ETFs also are effected by supply and demand, so they change price some with market conditions.

Some gee-whiz information on bond ETFs changing prices: These values change due to the new bonds having different rates than old bonds, bonds can be traded on the market so old bonds value can change.

For example: a company offered a one year bond a month ago with a yield of 1.2% (so it returns 0.1% per month or $0.10 per $100 per month), the company would sell you the bond for $98.80 and you would redeem it for $100 in a year (yield of 1.2%). This month however, the company offers bonds with a yield of 12% (so a yield of 1% per month), so this month you would buy a one year bond for $88 and redeem in a year for $100 (making your gain 12% or $12). The company’s bonds are backed by the company as it is today, so the market will adjust the prices of bonds to make the yield equal todays yield (12%).

So, you want to trade your 1.2% bond, but the current bond pays 12%. To trade you need to discount your bond, you have held your bond for one month, if the current (12%) bond was bough a month ago it would be worth $89 today (as the bond is worth 12%/12 months = 1% more per month, meaning it gains $1 per month). Therefore you would have to sell your bond for $89, even though you paid $98.80 the month before. This is why bond ETF funds can change in value - the underlying bonds in this fund change in value relative to todays yields for the same bonds.

 

ETF bond funds are some of the easiest ways to get into bonds, however know the returns are based on the bond market today. Today (May 2015) the returns from bonds are low, therefore if rates increase in the future the value the bond will be worth slightly less. If you buy these plan to hold them for quite a while to realize returns via the dividends.

Article by: Jacob K Lloyd

Jacob@startingwithstocks.com

Published: 3 July 2015

Last updated: 13 Sep 2015

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