Demystifying Bonds for the Average Investor
Bonds are considered one of the most essential parts of a well-balanced investment portfolio, but most investors are lost as to how bonds actually work. Even experienced investors only hold bonds as part of a mutual fund and don’t actually own bonds directly.
Unlike stocks, bonds are valued both by their face value as well as their interest payments. Navigating these two benefits can be difficult, which is why they say bond investors are the smartest guys on Wall Street. But bonds can be understood by even beginning investors, all it takes is the right tools to be successful.
Bonds pay a yield semi-annually but are generally displayed on an annual basis to avoid confusion. Other than the interest rate, bonds also have a face value that can rise or fall based on market conditions and interest rates. Finally, the time left until the bond matures, or pays the full face value, is part of how a bond is priced. The further away the maturation date, the more sensitive to interest rates it will be.
One of the most confusing issues for investors is how a bond is priced. Let’s say a bond has a face value of $1,000 and has a yield of 4 percent. To simplify matters, we won’t factor in the semi-annual nature of the bond. That means every year, the bond will pay out $40 in interest to investors. When it matures, the investor will also receive the $1,000 face value of the bond.
If the price of the bond falls though, that affects the yield. Let’s say the same bond falls to $950 – that would make the yield 4.21 percent instead. If the value of the bond rose to $1,050, then the rate would drop to 3.81 percent. Keep in mind that the face value is always $1,000 so regardless of how much you pay for the bond, $1,000 is always the final payout amount.
When interest rates change, bonds are the first asset to be affected. If interest rates rise, bond values will fall to compensate for the increased interest rate. On the other hand, if rates fall, investors will pay more money for the same bond.
Bond pricing can be complicated when statistics like duration are considered. Duration is the weighted average of the length of time until the recovery of the bond’s present value considering all future interest payments. While an understanding of the math involved isn’t necessary to be a bond investor, the most important thing to take away is the fact that time until maturity is critical when considering how its value will change with interest rates. Remember, the longer away the settlement date, the more volatility the bond will experience.