Investing in Bonds

Bonds are a common investment for people targeting a low-risk investment portfolioA group of financial instruments. More. One of the pieces of advice I gave my kids (see others in this post) is to never buy anything you don’t understand. In this post, I’ll tell you what you need to know so you can decide whether investing in bonds is appropriate for you.
What is a Bond?
A bondA form of debt issued by government entities and corporations. More is a loan you are giving the issuer. The parties to the transaction are exactly opposite of you taking out a loan. You’ll see the parallels if you compare the information in this post with that provided in my post on loans! When you buy a bondA form of debt issued by government entities and corporations. More, you are the lender. The issuer of the bondA form of debt issued by government entities and corporations. More is the borrower.
How Do Bonds Work?
The issuer of a bondA form of debt issued by government entities and corporations. More sells the bonds to investors (i.e., lenders). Every bondA form of debt issued by government entities and corporations. More has a face amount. Common face amounts are $100 and $1,000. The face value of the bondA form of debt issued by government entities and corporations. More is called the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More. It is equivalent to the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More on a loan. When the issuer first sells the bonds, it receives the face amount for each bondA form of debt issued by government entities and corporations. More.
The re-payment plan for a bondA form of debt issued by government entities and corporations. More is different than for a loan. When you take out a loan, you make payments that include interestA charge for borrowing money, most often based on a percentage of the amount owed. More and a portion of your principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. Over the life of your loan, all of your payments are the same (unless the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More is adjustable). By comparison, a bondA form of debt issued by government entities and corporations. More issuer’s payments include only the interestA charge for borrowing money, most often based on a percentage of the amount owed. More until the maturity date when it pays the final interestA charge for borrowing money, most often based on a percentage of the amount owed. More payment and returns the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More in full.
Before selling bonds, the issuer sets the couponThe interest payment on a loan. More rate and the maturity date of the bondA form of debt issued by government entities and corporations. More. The couponThe interest payment on a loan. More rate is equivalent to the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on a loan. The maturity date is the date on which the issuer will pay the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More to the owner of the bondA form of debt issued by government entities and corporations. More. It can vary from something very short, like a year, all the way to 30 years. In Europe, there are even bonds with maturity dates in 99 years. In the meantime, the issuer will pay coupons (interestA charge for borrowing money, most often based on a percentage of the amount owed. More) equal to the product of the couponThe interest payment on a loan. More rate and the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More, divided by the number of coupons issued per year. Coupons are often issued quarterly. For example, if you owned a bondA form of debt issued by government entities and corporations. More with a $1,000 par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More, a 4% couponThe interest payment on a loan. More rate and quarterly payments, you would get 1% of $1,000 or $10 a quarter in addition to the return of the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More on the maturity date.
What Price Will I Pay
You can buy bonds when they are first issued from the issuer or at a later date from other people who already own them. You can also sell bonds you own if you want the return of your initial investment before the bondA form of debt issued by government entities and corporations. More matures. If you buy and sell bonds, the sale prices will be the market price of the bonds.
Present Value
Before explaining how the market value is calculated, I need to introduce the concept of a present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More. A present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More is the value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More adjusted for the length of time between the date the calculation is done and the date the payment will be received. Specifically, the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More at an interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More of i of $X received in t years is:
The denominator of (1+i) is raised to the power of t to adjust for the time element.
Market Price = Present Value of Cash Flows
The market price of a bondA form of debt issued by government entities and corporations. More is the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of the future couponThe interest payment on a loan. More payments and principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More repayment at the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More at the time of the calculation is performed.
Interest Rate = Coupon Rate When Issued
The interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More when the bondA form of debt issued by government entities and corporations. More is issued is the couponThe interest payment on a loan. More rate! Because the issuer sells the bonds at par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More (the face amount of the bondA form of debt issued by government entities and corporations. More), the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More has to equal the market value. For the math to work, the couponThe interest payment on a loan. More rate must equal the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More at the time the bondA form of debt issued by government entities and corporations. More is initially sold.
Interest Rates after Issuance
If interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates change (more on that in a minute) after a bondA form of debt issued by government entities and corporations. More is issued, the market value will change and become different from the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More because the “i” in the formula above will change. When the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More increases, the price of the bonds goes down and vice versa.
Also, as the bondA form of debt issued by government entities and corporations. More gets closer to its maturity date, the exponent “t” in the formula will get smaller so it will have less impact on the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More, making the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More bigger. As such, all other things being equal, a bondA form of debt issued by government entities and corporations. More that has a shorter time to maturity will have a higher market price than a bondA form of debt issued by government entities and corporations. More that has a longer time to maturity. Remember that the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More is all paid at the end, so the market price formula is highly influenced by the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of the repayment of the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More.
How is the Interest Rate Determined
There are two factors specific to an individual bondA form of debt issued by government entities and corporations. More that influence the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More that underlies its price – the bond’s time to maturity and the issuer’s credit rating. In addition, there are broad market factors that influence the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates for all bonds. These factors influence the overall level of interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates as well as the shape of the yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More.
What is a Yield Curve
The interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on a bondA form of debt issued by government entities and corporations. More depends on the time until it matures. If I look at the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates on US government bonds today (March 7, 2019) at this site, I see the following:
The line on this graph is called a yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More. It represents the pattern of yields by maturity. In this case, there is some variation in yields up to 5 years and then the line goes up.
A “normal” yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More would go up continuously all the way from the left to the right of the graph. Up to five years, the chart above would be considered essentially “flat” and, above five years, would be considered normal. If the entire yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More went down, similar to what we see in the very short segment from one year to two years in this graph, it would be considered inverted.
Time to Maturity
The yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More along with the maturity date of a bondA form of debt issued by government entities and corporations. More influencethe interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More and therefore its market price. Looking at US Government bonds, the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates for bonds with maturities between 0 and 7 years are all around 2.5%.
The price of a 30-year bondA form of debt issued by government entities and corporations. More will reflect interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More of about 3%. If the yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More didn’t change at all, the same 30-year bondA form of debt issued by government entities and corporations. More would be priced using a 2.5% interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More in 23 years (when it has 7 years until maturity). With the lower interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More, the market value of the bondA form of debt issued by government entities and corporations. More will increase (in addition to the increase in market value because the maturity date is closer).
Credit Rating
The other important factor that affects the price of a bondA form of debt issued by government entities and corporations. More is its credit rating. Credit ratings work in the same manner as your credit score does. If you have a low credit score (see my post on credit scores for more information), you pay a higher interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More when you take out a loan. The same thing happens to a bondA form of debt issued by government entities and corporations. More issuer – it pays a higher interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More if it has a low credit rating.
Instead of having a numeric credit score, bonds are assigned letters as credit ratings. There are several companies that rate bonds, with Standard and Poors (S&P), Moodys and Fitch being the biggest three. When you buy a bondA form of debt issued by government entities and corporations. More (more on that later), the credit rating for the bondA form of debt issued by government entities and corporations. More will be quite clearly stated.
The graph below summarizes information I found on the website of the St. Louis Federal Reserve Bank (FRED).
It shows the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates on corporate bonds with different credit ratings on February 28, 2019. As you can see, there is very little difference in the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates of bonds rated AAA, AA and A, with a slightly higher interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More for bonds rated BBB. Bonds with BBB ratings and higher are considered investment grade.
Bonds with ratings lower than BBB are called less-than-investment grade, high yield or junk. You can see that the interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates on bonds with less-than-investment grade ratings increase very rapidly, with C-rated bonds having interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates close to 12%.
What are the Risks
There are two risks – default and market – that are inherent in bonds themselves and a third – inflation – related to using them as an investment.
Defaults
Default riskThe possibility that something bad will happen. More is the chance that the issuer will default or not make all of its couponThe interest payment on a loan. More payments or not return the full par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More when it is due. When an issuer defaults on a bondA form of debt issued by government entities and corporations. More, it may pay the bondA form of debt issued by government entities and corporations. More owner a portion of what is owed or it could pay nothing. The percentage of the amount owed that is not repaid is called the “loss given default.” If the loss given default is 100%, you lose the full amount of your investment in the bondA form of debt issued by government entities and corporations. More, other than couponThe interest payment on a loan. More payments you received before the default. At the other extreme, if the loss given default is only 10%, you would receive 90% of what is owed to you.
Issuers of bonds with low credit ratings are considered riskier, meaning they are expected to have a higher chance that they will default than issuers with high credit ratings. I always find this chart from S&P helpful in understanding default riskThe possibility that something bad will happen. More.
It shows two things – the probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of an issuer defaulting increases as the credit rating gets lower (e.g., the B line is higher than the A line) and the probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of default increases the longer the time until maturity.
These increases in the probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of default correspond to increases in riskThe possibility that something bad will happen. More. Recall from the previous section that interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates increase as there is a longer time to maturity when the yield curveThe relationship between interest rates and the maturities of bonds with the same quality and characteristics. More is normal and as the credit rating gets lower. The higher interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are compensation to the owner of the bondA form of debt issued by government entities and corporations. More for the higher riskThe possibility that something bad will happen. More of default.
When you read the previous section and saw you could earn between just under 12% on a C-rated bondA form of debt issued by government entities and corporations. More, you might have gotten interested. However, it has almost a 50% chance of defaulting in 7 years! The trade-off is that you’d have to be willing to take the riskThe possibility that something bad will happen. More that the issuer would have a 26% chance of defaulting in the first year and a 50% chance by the seventh year! It makes the 12% couponThe interest payment on a loan. More rate look much less attractive.
Changes in Market Value
As I mentioned above, you can buy and sell bonds in the open market as an alternative to holding them to maturity. In either case, you will receive the couponThe interest payment on a loan. More payments while you own the bondA form of debt issued by government entities and corporations. More, as long as the issuer hasn’t defaulted on them. If you buy a bondA form of debt issued by government entities and corporations. More with the intention of selling it before it matures, you have the riskThe possibility that something bad will happen. More that the market value will decrease between the time you purchase it and the time you sell it. Decreases in market values correspond to increases in interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates. These increases can emanate from changes in the overall market for bonds or because the credit rating of the bondA form of debt issued by government entities and corporations. More has deteriorated.
If you hold a bondA form of debt issued by government entities and corporations. More to maturity and it doesn’t default, the amount you will get when it matures is always the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. So, you can eliminate market riskThe possibility that something bad will happen. More if you hold a bondA form of debt issued by government entities and corporations. More to maturity.
Interest Doesn’t Keep Up with Inflation
The third risk – inflation risk – is the risk that inflation rates will be higher than the total return on the bond. Let’s say you buy a bond with a $100 par value for $90, it matures in 5 years and the coupons are paid at 2%. Using the formulas above, I can determine that your total return (the 2% coupons plus the appreciation on the bond from $90 to $100 over 5 years) is 4.3%. You might have purchased this bond as part of your savings for a large purchase. If inflation caused the price of your large purchase to go up at 5% per year, you wouldn’t have enough money saved because your bond returned only 4.3%. Inflation risk exists for almost every type of invested asset you purchase if your purpose for investing is to accumulate enough money for a future purchase.
How are They Taxed
There are two components to the return you earn on a bondA form of debt issued by government entities and corporations. More – the coupons and appreciation (the difference between what you paid for it and what you get when you sell it or it matures).
Tax on Coupons and Capital Gains
The coupons are considered as interestA charge for borrowing money, most often based on a percentage of the amount owed. More in the US tax calculation. InterestA charge for borrowing money, most often based on a percentage of the amount owed. More is included with your wages and many other sources of income in determining your taxes which have tax rates currently ranging from 10% to 37% depending on your income.
The difference between your purchase price and your sale price or the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More upon maturity is considered a capital gain. In the US, capital gains are taxed in a different manner from other income, with a lower rate applying for most people (0%, 15% or 20% depending on your total income and amount of capital gains).
States that have income taxes usually follow the same treatment with lower tax rates than the Federal government, but not always.
Some Bonds are Taxed Differently
Within this framework, though, not all bonds are treated the same. The description above applies to corporate bonds. Bonds issued by the US government are taxed by the Federal government but the returns are tax-free in most states.
Some bonds are issued by a state, municipality or related entity. The interestA charge for borrowing money, most often based on a percentage of the amount owed. More on these bonds is not taxed by the Federal government and is usually not taxed if you pay taxes in the same state that the issuer is located. Capital gains on these bonds are taxed in the same manner as corporate bonds.
Included in this category of bonds are revenue bonds. Revenue bonds are issued by the same types of entities, but are for a specific project. They have higher credit riskThe possibility that something bad will happen. More than a bondA form of debt issued by government entities and corporations. More issued by a state or municipality because they are backed by only the revenues from the project and not the issuer itself.
The manner in which a bondA form of debt issued by government entities and corporations. More is taxed is important to your buying decision as it affects how much money you will keep for yourself after buying the bondA form of debt issued by government entities and corporations. More. You should consult your broker or your tax advisor if you have any questions specific to your situation.
Do They Have Other Features
If you decide to buy bonds, there are some features you’ll want to understand or, at a minimum, avoid. Some of the types of bonds with these distinctive features are:
Treasury Inflation-Protected Securities or TIPS
TIPS are similar to US Government bonds except that the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More isn’t constant. The impact of inflation as measured by the Consumer Price Index is determined between the issue date and the maturity date. If inflation over the life of the bondA form of debt issued by government entities and corporations. More has been positive, the owner of the bondA form of debt issued by government entities and corporations. More will be paid the original par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More adjusted for the impact of inflation. If it has been negative, the owner receives the original par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More. In this way, the owner’s inflation riskThe possibility that something bad will happen. More is reduced. It is completely eliminated if the owner purchased the bondA form of debt issued by government entities and corporations. More to buy something whose value increases exactly with the Consumer Price Index.
Savings or EE Bonds
Savings bonds are a form of US Government bondA form of debt issued by government entities and corporations. More. You can buy them with par values of as little as $25. They can be purchased for terms up to 30 years. Currently, savings bonds pay interestA charge for borrowing money, most often based on a percentage of the amount owed. More a 0.1% a year. The interestA charge for borrowing money, most often based on a percentage of the amount owed. More is compounded semi-annually and paid to the owner with the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More when the bondA form of debt issued by government entities and corporations. More matures. With the currently very low interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates, these bonds are very unattractive.
Zero-Coupon Bonds
The issuer of a zero-coupon bondA form of debt issued by government entities and corporations. More does not make interestA charge for borrowing money, most often based on a percentage of the amount owed. More payments. Rather, when it issues the bondA form of debt issued by government entities and corporations. More, the price is less than the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More. In fact, the price is the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of just the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More payment. So, instead of paying the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More for a newly issued bondA form of debt issued by government entities and corporations. More and getting couponThe interest payment on a loan. More payments, the buyer pays a much lower price and gets the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More when the bondA form of debt issued by government entities and corporations. More matures.
I don’t know all the details, but believe that, in the US, the owner needs to pay taxes on the appreciation in the value of the bondA form of debt issued by government entities and corporations. More every year as if it were interestA charge for borrowing money, most often based on a percentage of the amount owed. More and not as a capital gain on sale. As such, it is better to own a zero-coupon bondA form of debt issued by government entities and corporations. More in a tax-deferred or tax-free account, such as an IRAA personal retirement savings plan available in the US. There are two types of IRA:
• Traditional - No taxes are paid on the contributions or any changes in the market value of the investments ... More, a 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or health savings account(HSA) An account that helps fund your share of medical expenses if you have a high-deductible health insurance plan (as defined by the IRS). You can contribute money to the account without paying taxe... More. I’ve owned one zero-coupon bondA form of debt issued by government entities and corporations. More – it was my first investment in an IRAA personal retirement savings plan available in the US. There are two types of IRA:
• Traditional - No taxes are paid on the contributions or any changes in the market value of the investments ... More. If you want to buy a zero-coupon bondA form of debt issued by government entities and corporations. More, I suggest talking to your broker or tax advisor to make sure you understand the tax ramifications.
Callable Bonds
A call is a financial instrumentAny investment that you purchase. Examples include an exchange-traded fund, a mutual fund, stock in an individual company, a bond and a money market fund. There are also many more complex financia... More that gives one party the option to do something. In this case, the issuer of the bondA form of debt issued by government entities and corporations. More is given the option to give you the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More earlier than the maturity date. When the issuer decides to exercise this option, the bondA form of debt issued by government entities and corporations. More is said to be “called.” The bondA form of debt issued by government entities and corporations. More contract includes information about when the bondA form of debt issued by government entities and corporations. More is callable and under what terms. If you purchase a callable bondA form of debt issued by government entities and corporations. More, you’ll want to understand those terms.
Issuers are more likely to call a bondA form of debt issued by government entities and corporations. More when interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates have decreased. When interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates go down, the issuer can sell new bonds at the lower interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More and use the proceeds to re-pay the callable bondA form of debt issued by government entities and corporations. More, thereby lowering its cost of debt.
In a low-interest rate environment, such as exists today, a callable bondA form of debt issued by government entities and corporations. More isn’t much different from a non-callable bondA form of debt issued by government entities and corporations. More as it isn’t likely to get called. If interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates were higher, a non-callable bondA form of debt issued by government entities and corporations. More with the same or similar credit quality and couponThe interest payment on a loan. More rate is a better choice than a callable bondA form of debt issued by government entities and corporations. More. If the callable bondA form of debt issued by government entities and corporations. More gets called, you will have cash that you now need to re-invest at a time when interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are lower than when you initially bought the bondA form of debt issued by government entities and corporations. More. (Remember that the reason that callable bonds get called is that interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates have gone down.)
Convertible Bonds
Convertible bonds allow the issuer to convert the bondA form of debt issued by government entities and corporations. More to some form of stock. As will be explained below, stocks are riskier investments than bonds. If you buy a convertible bondA form of debt issued by government entities and corporations. More, you’ll want to understand when and how the issuer can convert the bondA form of debt issued by government entities and corporations. More and consider whether you are willing to own stock in the company instead of a bondA form of debt issued by government entities and corporations. More.
How Does Investing in Bonds Differ from Other Investments
There are two other types of financial instruments that people consider buying as common alternatives to bonds – bondA form of debt issued by government entities and corporations. More mutual funds and stocks. I’ll briefly explain the differences between owning a bondA form of debt issued by government entities and corporations. More and each of these alternatives.
Bond Funds
There are two significant differences between owning a bondA form of debt issued by government entities and corporations. More fund and own a bondA form of debt issued by government entities and corporations. More.
A Bond Fund with the Same Quality Bonds Has Less Default Risk
If you own a bondA form of debt issued by government entities and corporations. More fund, you are usually buying an ownership share in a pool containing a relatively large number of bonds. Owning more bonds increases your diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More (see this post for more on that topic). With bonds, the biggest benefit from diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is that it reduces the impact of a single issuer defaulting on its payments. If you own one bondA form of debt issued by government entities and corporations. More, the issuer defaults and the loss given default is 50%, you’ve lost 50% of your investment. If you own 100 bonds and one of them defaults with a 50% loss given default, you lose 0.5% of your investment.
A Bond Fund Has Higher Market Risk than Owning a Bond to Maturity
Recall that you eliminate market riskThe possibility that something bad will happen. More if you hold a bondA form of debt issued by government entities and corporations. More until it matures. Almost all bondA form of debt issued by government entities and corporations. More funds buy and sell bonds on a regular basis, so the value of the bondA form of debt issued by government entities and corporations. More fund is always the market price of the bonds. Because the market price of bonds can fluctuate, owners of bondA form of debt issued by government entities and corporations. More funds are subject to market riskThe possibility that something bad will happen. More. I cover the market riskThe possibility that something bad will happen. More of bondA form of debt issued by government entities and corporations. More funds much more extensively in this post on the All Seasons portfolio.
Stocks
When you buy stock in a company, you have an ownership interestA charge for borrowing money, most often based on a percentage of the amount owed. More in the company. When you own a bondA form of debt issued by government entities and corporations. More, you are a lender but have no ownership rights. To put these differences in perspective, owning a stock is like owning a share in vacation home along with other members of your extended family. By comparison, owning a bondA form of debt issued by government entities and corporations. More is like being the bank that holds the mortgage on that vacation home.
Stocks Have More Market Risk
The market riskThe possibility that something bad will happen. More for stocks is much greater than for bonds. Ignoring defaults for the moment, the issuer has promised to re-pay you the par valueThe face amount of a bond. It is equivalent to the principal on a loan. The issuer gets the par value when it issues the bond and re-pays the par value when the bond matures. More of the bondA form of debt issued by government entities and corporations. More plus the coupons, both of which are known and fixed amounts. With a stock, you are essentially buying a share of the future profits, whose amounts are very uncertain.
Stocks Have More Default Risk
The default riskThe possibility that something bad will happen. More for stocks is also greater than for bonds. When a company gets in financial difficulties, there is a fixed order in which people are paid what they are owed. Employees and vendors get highest priority, so get paid first. If there is money left over after paying all of the employees and vendors, then bondholders are re-paid. After all bondholders have been re-paid, any remaining funds are distributed among stockholders. Because stockholders take lower priority than bondholders, they are more likely to lose some or all of their investment if the company experiences severe financial difficulties or goes bankrupt.
Companies often issue bonds on a somewhat regular basis. When a bondA form of debt issued by government entities and corporations. More is issued, it is assigned a certain seniority. This feature refers to the order in which the company will re-pay the bonds if it encounters financial difficulties. If you decide to invest in bonds of individual companies, especially less-than-investment grades bonds, you’ll want to understand the seniority of the particular bondA form of debt issued by government entities and corporations. More you are buying because it will affect the level of default riskThe possibility that something bad will happen. More. Lower seniority bonds have lower credit ratings, so the credit rating will give you some insight regarding the seniority.
When is Investing in Bonds Right for Me
There isn’t a right or a wrong time to buy a bondA form of debt issued by government entities and corporations. More, just as is the case with any other financial instrumentAny investment that you purchase. Examples include an exchange-traded fund, a mutual fund, stock in an individual company, a bond and a money market fund. There are also many more complex financia... More. The most important thing about buying a bondA form of debt issued by government entities and corporations. More is making sure you understand exactly what you are buying, how it fits in your investment strategy and its risks.
Low-Risk Investment Portfolio
If you are interested in a low riskThe possibility that something bad will happen. More investment portfolioA group of financial instruments. More, US Government and high-quality corporate bonds might be a good investment for you. As you think about this type of purchase, you’ll also want to think about the following considerations.
How Long until You Need the Money
If you are saving for a specific purchase, you could consider buying small positions in bonds of several different companies or US government bonds with maturities corresponding to when you need the money. If you’ll need the money in less than a year or two, you might be better off buying a certificate of depositA savings certificate, usually issued by a commercial bank, that has a stated maturity and interest rate. Certificates of deposit, often called CDs, are insured by the Federal Deposit Insurance Corp... More or putting the money in a money market or high yield savings account. If it is a long time until you’ll need the money and you think interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates might go up, you’ll want to consider whether you can buy something with a maturity sooner than your target date without sacrificing too much yield so you can buy another bondA form of debt issued by government entities and corporations. More in the future at a higher interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More.
How Much Default Risk are You Willing to Take
If you aren’t willing to take any default riskThe possibility that something bad will happen. More, you’ll want to invest in US government bonds. If you are willing to take a little default riskThe possibility that something bad will happen. More, you can buy high-quality (e.g., AAA or AA) corporate bonds. You’ll want to buy small positions is a fairly large number of companies, though, to make sure you are diversified.
How Much Market Risk are You Willing to Take
If you are willing to take some market riskThe possibility that something bad will happen. More, you can more easily attain a diversified portfolioA group of financial instruments. More by investing in a bondA form of debt issued by government entities and corporations. More mutual fund. As mentioned above, you’ll want to consider whether you think interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates will go up or down during your investment horizon. If you think that are going to go up, there is a higher riskThe possibility that something bad will happen. More of market values going down than if you think they will be flat. In this situation, a bondA form of debt issued by government entities and corporations. More fund becomes somewhat riskier than buying bonds to hold them to maturity. If you think interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are going to go down, there is more possible appreciation than if you think they will be flat.
High-Risk Investment Portfolio
If you want to make higher return and are willing to take more default riskThe possibility that something bad will happen. More, you can consider buying bonds of lower quality. As shown in the chart above, non-investment grade bonds pay coupons at very high interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates. However, you need to recognize that you are taking on significantly more default riskThe possibility that something bad will happen. More. One approach for dabbling in high-yield bonds is to invest in a mutual fund that specializes in those securities. In that way, you are relying on the fund manager to decide which high-yield bonds have less default riskThe possibility that something bad will happen. More. You’ll also get much more diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More than you can get on your own unless you have a lot of time and money to invest in the bonds of a large number of companies.
Where Do I Buy Bonds and Bond Funds
You can buy individual bonds and bondA form of debt issued by government entities and corporations. More mutual funds at any brokerage firm. Many banks, particularly large ones, have brokerage divisions, so you can often buy bonds at a bank. This article by Invested Wallet provides details on how to open an account at a brokerage firm.
All US Government bonds, including Savings Bonds and TIPS can be purchased at Treasury Direct, a service of the US Treasury department. You’ll need to enter your or, if the bondA form of debt issued by government entities and corporations. More is a gift, the recipient’s social security number and both you and, if applicable, the recipient need to have accounts with Treasury Direct. US Savings Bonds can be bought only through Treasury Direct. You can buy all other types of government bonds at any brokerage firm, as well.
As discussed in this post, it is best to buy bonds in a tax-advantaged account, such as an IRAA personal retirement savings plan available in the US. There are two types of IRA:
• Traditional - No taxes are paid on the contributions or any changes in the market value of the investments ... More, 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More, Tax-Free Savings AccountA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More (TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More) or Registered Retirement Savings PlanA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More (RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More) than a taxable account. You pay tax on the coupons every year when bonds are held in a taxable account, but you get the benefit of compounding without paying taxes along the way in a tax-advantaged account.
Susie Q is a retired property-casualty actuaryA professional who assesses and manages the risks of financial investments, insurance policies and other potentially risky ventures. Source: www.investopedia.com/terms/a/actuary.asp More and mother of two adult children. As her children were moving from their teens into their 20s, she found she was frequently a resource on many, many financial decisions and she had insights and information she could provide to them on a wide array of financial decisions. She spent a significant portion of my career building statistical models of all of the financial risks of an insurance company and interpreting their findings to help senior management make better financial decisions. She is the primary author at Financial IQ by Susie Q and volunteers with other organizations related to financial education.
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