Investing in Bonds: The Basics
Bonds aren’t the most popular investment to talk about. Investors tend to view them much like a side of broccoli in a steak dinner. The steak (stocks) may garner all the attention, but experienced investors know that it takes a balanced portfolio to be financially healthy.
Maybe you can speak at length about the prospects of XYZ stock or discuss in detail how its valuation multiple makes it an attractive buy right now, but the moment someone mentions bonds, your eyes glaze over and you tune out of the conversation.
You aren’t alone. The bond market is arguably the most misunderstood market on Wall Street simply due to a lack of basic bond know-how. Once you understand what a bond is and how it’s valued, you’ll be able to speak about and invest in bonds with confidence.
Debt isn’t all bad
A bond is a loan issued to governments or corporations that comes with a fixed interest rate over a preset period of time. It works exactly the same as when you take out a loan to finance the purchase of something such as a car except instead of borrowing money from the bank, you become the lender the company or government is borrowing from.
These debt instruments typically pay out interest on a semi-annual basis and are known as fixed-income securities. Investors can trade bonds in several ways. They can hold the bond until maturity and collect the interest, or they can trade the bonds before maturity and take advantage of any price appreciation that occurs.
Bonds are issued with credit ratings as well with higher credit ratings paying less interest than those with lower credit ratings. Bonds that have a rating of AAA to BBB are known as investment grade bonds because the issuer has a high or medium credit quality and there is a low risk that the company will go delinquent on its debt. Bonds with a rating of BB or lower are called high-yield bonds or “junk” bonds because there is a higher risk of a company defaulting on its loans.
Pricing a bond
Bond prices and interest rates have an inverse relationship meaning that as one goes up, the other goes down and vice versa. If you’re buying a bond with no intention of trading it – you’re just holding it for the interest – then pricing changes won’t matter to you. But if you’re trying to take advantage of any opportunity that presents itself, then you’ll want to know how bonds can be profitable beyond yield.
Let’s say you bought a bond with a par value of $1,000 and offers a 5% yield netting you $50 semi-annually. Regardless of what happens with the face value of the bond, the semi-annual amount you’ll earn will not change. Now let’s assume that interest rates are hiked by 1%. In order for the bond to trade at parity, it will need to offer a 6% yield. In order to do that, the value of the bond needs to fall so that the face value will equal a 6% yield. In this case, the value would drop to $833. A 6% yield would then give an investor $50 semi-annually.
Bonds are considered one of the pillars of a balanced portfolio along with stocks and money-market assets. While bonds are often dismissed as an asset class that’s taken for granted, investors who understand how the bond market works can boost returns and improve their portfolio’s efficiency.