Investing 101: what are bonds?
In the past few articles of the Investing 101 series, we looked at stocks, the stock market, market indices, and mutual funds and index funds. Now, it is time to shift gears and look at another important asset class: bonds. This is everything you need to know about bonds, all in one place.
Remember all the way back from Part 1: What is investing? that there are only two basic ways for money to make money: purchase appreciating assets or lend money out and charge interest.
There are a myriad of assets which can appreciate in value, such as real estate, private companies, commodities, or even antiques, just to name a few. Ownership of public companies via the stock market just happens to be overwhelmingly the largest and most publicly accessible asset market to investors.
In a similar way, there are a myriad of ways to lend your money out, such individual loans to friends or family, private business loans, and peer-to-peer lending to strangers, just to name a few. Bonds, however, represent the largest and most publicly assessible debt market to investors. You can think of bonds as publicly available loans, in the same way that stocks are publicly available equities.
Bonds are loans
Bonds represent loans to the issuer of the bond. When a company needs to raise capital, it can either offer a portion of its equity for sale (i.e., stocks, which we’ve already covered extensively), or it can issue a bond.
Every bond has the following characteristics:
Face value. A bond’s face value represents the principal of the loan.
Coupon. A bond’s coupon represents the interest rate on the loan.
Maturity. A bond’s maturity represents the duration of the loan.
When you “purchase” a bond, you are in fact loaning money to the issuer of the bond. The face value is the “cost” of the bond, which is also the amount of the loan. At fixed intervals, the borrower pays you interest, as determined by the coupon rate. Finally, at the maturity date, you will redeem the bond and receive the original principal amount back. The interest payments you received represent your profit or your returns.
For example, this Microsoft (MSFT) bond, excellently named 594918BY9, was originally issued in 2017. It pays an interest rate of 3.3% and reaches maturity in 2027, which would have been 10 years from the original issue date. So, if you purchased this bond in 2017 and held it until 2027, you provided a 10-year loan to Microsoft at 3.3% interest.
Differences between bonds and stocks
Bonds differ from stocks in two very important ways. First, bonds are loans and stocks are equity. This is a fundamental difference in your relationship with the company. When you purchase a bond, you have a creditor stake in the company. They owe you money and are obligated to pay you back. When you purchase a share of stock, you have an ownership stake in the company. The company doesn’t owe you anything; you are one of the company’s owners. You take on portion of the company’s assets, liabilities, revenues, and expenses, whatever those values might be.
Therefore, broadly speaking, bonds are less risky than stocks, because financially troubled companies still have to pay off their creditors, even if the company’s valuation declines. And in the event of bankruptcy, the company must liquidate all of its assets and attempt to settle remaining debts. This means that bond holders have priority in getting paid first. It is only after debts are settled that equity holders are entitled to whatever remains. Usually, nothing remains, since the company likely went bankrupt in the first place because its liabilities exceeded its assets and it could not generate enough cash flow to keep operating.
For example, when Lehman Brothers went bankrupt in 2008 during the global financial crisis, the company’s creditors ultimately recovered approximately 21% of outstanding debts, or an average of 21 cents on the dollar. This still represents a massive loss, although not a total loss. On the other hand, Lehman Brother’s stock went to 0, so stockholders suffered total loss.
Conversely, bonds will typically return less than stocks, because the interest you will receive on a bond is fixed when the bond is issued. With stocks, however, there is no ceiling on the company’s trajectory, so your ownership stake can grow incredibly valuable over time.
The second major difference between bonds and stocks is that non-corporate entities can issue bonds. This includes entities such as local and municipal governments and even school districts. For example, school boards in Texas can issue bonds to raise money for a project. In fact, governments on all levels can issue bonds. Bonds issued by the United States government are also known as Treasuries, Treasury bills, or T-bills. On the other hand, you cannot purchase ownership stake in a government. Therefore, bonds allow you to do business with a greater variety of entities, including non-corporate ones.
Bond ratings
Although bonds are less risky investments than stocks, bonds still have risks. The most obvious risk of investing in bonds is that the borrower might default on the loan. For this reason, the credit-worthiness of the bond issuer is extremely important. There are three major agencies, Moody’s, Standard & Poor’s, and Fitch, which publish credit scores of corporate bond issuers. These credit scores are based on the bond issuer’s financial strength and their perceived ability to honor their debts. The follow table shows the rating scores used by these three rating agencies, ranked from strongest to weakest:
Bonds rated above BBB- (or Baa3 on Moody’s scale) are considered “investment-grade” bonds. These bonds are issued by trustworthy entities with strong financial standing and carry a low risk of default. Bonds which are not “investment-grade” are also known as “high-yield bonds” or “junk bonds”. These issuers are felt to be less financially stable and therefore carry a higher risk of default.
Note that a bond’s yield, or coupon, is usually inversely correlated with the rating score of its issuer. For example, a AAA-rated company can issue bonds with a very low yield, for example, 2%, and still find investors willing to provide this loan to them, because the risk of default is minimal and the returns are virtually guaranteed. On the other hand, a struggling company with a rating of C will be hard-pressed to find anyone willing to lend it money for fear of default. Therefore, it must issue bonds with a much higher yield, for example, 8%, in order to entice investors who are willing to take a risk.
The rating system is not perfect, and sometimes, ratings drive performance as much as performance drives ratings. For example, a struggling company might get their credit rating downgraded from BBB- to BB+. While this represents just a one tier downgrade, it turns the company’s bonds from investment grade to junk status. This instantly makes the company’s bonds much less attractive to investors, making it harder for the company to raise cash to continue operations, which can cause further deterioration in the company’s financial status, leading to further rating downgrades.
U.S. Treasuries
Bonds issued by the United States government are not subject to credit ratings. Treasuries are backed by the “full faith and credit” of the United States. The United States is a sovereign power, and generally speaking, bonds issued by sovereign powers are less likely to default, because sovereign powers also have control over monetary policy and government mints to simply print more money. However, sovereign defaults do occur on occasion, usually in setting of government instability/regime change or economic collapse. Many African and South American countries with chronic economic or political instability are notable for frequent sovereign debt crises. Some notable examples of recent major sovereign defaults outside these regions include Russia in 1998 and Greece in 2015.
Since its founding, the United States government has never defaulted on any debt and has always repaid its bonds. This includes tumultuous periods such as the Civil War, Great Depression, and both World Wars. In financial circles, the “full faith and credit” of the United States government is the closest thing to a guarantee that exists. The U.S. Dollar is also used globally as the world’s #1 reserve currency. U.S. Treasuries are therefore considered one of the lowest-risk investments in the entire world.
Other bond risks
Beyond the risk of default, bonds have a few other, less obvious risks:
Interest rate risk. On the secondary market, interest rates affect the resale price of a bond. There is an inverse relationship between interest rates and bond prices. For example, if you have a bond that pays 5% yield, and interest rates fall to 3%, your bond becomes more valuable to another investor because they can no longer get a 5% yield from the same bond issuer. On the other hand, if interest rates rise, your bond becomes less valuable, because someone can simply purchase a new bond with a higher yield directly from the bond issuer.
Inflation risk/opportunity cost. When you purchase a bond, you are committing to receiving a predetermined rate of return on your money. If the bond has a low yield, and/or if the rate of inflation increases significantly, it is possible that the bond returns do not actually beat inflation. Overall, bond returns generally do not beat the returns of other asset classes, leading to opportunity cost in giving up potential returns when you invest in bonds.
Call risk. Some bonds are “callable”, which means that the issuer can purchase the bond back from the investor prior to maturation. This usually happens when interest rates fall and the issuer no longer wants to be “on the hook” for paying a higher rate on bonds it previously issued. This is akin to someone paying off a loan early, or re-financing a loan at a lower interest rate. The bond investor doesn’t lose anything in this scenario, but their returns will be less than they originally anticipated.
Liquidity risk. Some bonds are not highly liquid on the secondary market, meaning that if you wanted to exit your bond investment prior to maturation, you might have difficulty finding a buyer. U.S. Treasuries have an extremely active and liquid secondary market, but the same is not always true for some corporate bonds.
Bond benefits
So why do investors buy bonds? Many investors keep a portion of their total assets in bonds for several reasons:
Bonds are less risky and less volatile than stocks. Although the likelihood of the stock market going to zero is remote, the stock market does experience severe downturns. Some investors prefer giving up potential returns for the safety of more conservative investments. Bonds offer better capital preservation than stocks, especially in the short-term. For example, during the 2007 to 2008 global financial crisis, the Vanguard S&P 500 Index Fund experienced a maximum loss of -51%, but the Vanguard Total Bond Index Fund experienced a maximum loss of just under 4%.
Bonds are not highly correlated with the stock market. This means that bonds are often used as a way to diversify a portfolio. Modern portfolio theory has revealed that diversification with multiple negatively-correlated assets can result in better results than holding a single type of asset class. Adding bonds to a stock portfolio is a common practice and is covered in more detail in Investing 101: Portfolios and asset allocation.
Bonds pay predictable returns. Not all stocks pay dividends, and those that do usually pay dividends quarterly, semi-annually, or annually. Stock dividends are also subject to change and sometimes companies stop dividend payments altogether. Bonds, on the other hand, pay interest monthly, and the payment amount is pre-defined. Therefore, bonds fall under a class of assets known as “fixed-income assets”. Bonds can provide a consistent and reliable income stream for investors. This may be less appealing to a younger investor who is more interested in total portfolio growth, but becomes very important for people at or near retirement age who are looking to live off of their nest egg instead.
Hypothetical $10,000 portfolio starting January 2007. During the global financial crisis, the S&P 500 lost 51% in less than 2 years. Bond funds were relatively unaffected.
For all of these reasons, traditional investment advice typically recommends a portfolio of both stocks and bonds, weighted in favor of stocks when the investor is young (to provide long-term growth), but gradually shifting to more bonds as the investor ages, so that by the time the investor gets to retirement age, the portfolio is more heavily weighted towards bonds to provide both capital preservation and a monthly income. The ratio of stocks versus bonds (and potentially other asset classes) in a portfolio is known as asset allocation, and the deliberate shift in portfolio composition over time is known as rebalancing.
Bond indices and bond funds
As with stocks, many investors do not purchase individual bonds. Doing so can be a hassle, and bond markets can be quite confusing to a novice investor who is unfamiliar with current market conditions and current interest rates. Also, the need to diversify holds true for bonds just as it does for stocks. One prominent exception to this is U.S. government treasuries, which investors can directly purchase from the government at https://treasurydirect.gov/.
Instead, many bond investors purchase bond funds. A bond fund holds a “basket of bonds” in the same way that a stock fund holds a basket of stocks. Bond funds offer additional diversification over buying individual bonds by holding bonds from a variety of issuers. Additionally, bond funds hold bonds with different maturity dates, such that at any given time, some existing bonds are maturing and newly issued bonds are being bought, and therefore provide diversification in terms of interest rate risk as well.
Popular bond funds include so-called “Total Bond Market” funds, such as Vanguard’s Total Bond Market Index Fund (VBTLX), or the Fidelity U.S. Bond Index Fund (FXNAX). When it comes to bond funds, all of the characteristics of mutual funds which I previously discussed in Investing 101: Mutual funds, such as NAV, expense ratio, AUM, list of holdings, etc., still apply.
Note that bond indices do not work quite the same way as a cap-weighted stock index, as there is no good debt equivalent to market cap. Also, funds such as VBTLX only invest in government treasuries and investment-grade bonds. This can be confirmed by examining VBTLX’s holdings, which confirms that no bonds lower than BBB are included in the fund. In other words, junk bonds are not included.
Instead, many brokerages offer a separate fund for the riskier junk bonds. For example, Vanguard’s version is the Vanguard High-Yield Corporate Fund (VWEAX). The fund’s description notes “Although this is a bond fund, high-yield bonds tend to have volatility similar to that of the stock market.” As previously discussed, junk bonds offer higher returns than investment-grade bonds, but the risk of default is also higher. As with almost all investments, the relationship between risk and returns is maintained.
Summary:
Bonds are loans provided to the issuer.
Bond owners have a creditor relationship with the issuer, whereas stock owners have an equity stake.
Compared to the stock market, bonds provide lower volatility and more predictable, fixed income, at the cost of lower total returns in the long term.
Bonds are rated by the credit score of the issuer.
U.S. Treasuries are bonds sold by the U.S. government. The U.S. government is not subject to credit ratings.
Most investors buy bond funds instead of individual bonds.
Stocks and bonds form the backbone of all investment portfolios. In fact, many people believe that stocks and bonds are the only asset classes that an investor needs. However, in Part 8: Alternative investments, we will briefly explore so-called “alternative investments” and their merits. Happy investing!
