Basics of Investing & Portfolio Management

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What are bonds?

Lesson 7

In this section, we will explain what bonds are and how they work.
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What are bonds?

The bond market doesn’t get as much attention as the stock market. Media coverage is scarcer and the average investor doesn’t have as much access to information. That’s probably because bonds normally pay out lower returns than stocks and most investors see stocks as a better chance of earning skyrocketing returns. However, investing in bonds is a great way to diversify and balance your portfolio.

The bond market is becoming more and more popular among institutional and large retail investors. The US bond market has a value of about $40 trillion, which is more than double the value of the stock market. Internationally, the bond market is estimated to be valued at over $100 trillion, compared to the stock market’s $64 trillion value.

Now, what are bonds exactly?

Bonds are simply loans that investors make to large organizations, like companies, cities or national governments. A bond can be thought of as a contract, where an investor (lender) lends money to an organization (borrower), who promises to pay that money back at an agreed-upon date in the future. In the meantime, the borrower makes periodic interest payments to the lender as agreed upon in the contract.

Basic components of a bond

  1. Price: it is what you pay for the bond. It fluctuates and it is often affected by the forces of the economy and the markets.
  2. Par value: it is the value of the bond at its maturity. What the organization will pay you at the end of the contract.
  3. Coupon: the coupon rate is the amount of interest that you will get paid periodically for holding the bond.
  4. Maturity: it is the “life” of the bond. At the maturity date, the organization must pay you the par value. We have three types: short term bonds (up to 2 years), medium-term bonds (from 2 to 10 years), and long term bonds (more than 10 years).
  5. Yield to Maturity: is the expected annual return on a bond if you were to hold it (not sell it) until maturity. (This concept is a bit more advanced, we will explain it in future sections).

Let’s look at an example to bring the point home:

Laura’s SmartPies Company needed to raise another $10,000 to expand to the Asian markets. Instead of offering more ownership (or selling stock), she decided to borrow the money from you. In exchange, she promised to pay you back after 5 years. Also, she paid you 5% interest per year (coupon rate) to entice you to lend her the $10,000. Let’s see how this looks like:

You: Lent $10,000 (Principal) to Laura 5 years ago (Maturity)

Laura: She paid 5% of the Principal every year and returned it at Maturity (5 years)

Year 1: 5% x $10,000 = $500 Interest Paid

Year 2: 5% x $10,000 = $500 Interest Paid

Year 3: 5% x $10,000 = $500 Interest Paid

Year 4: 5% x $10,000 = $500 Interest Paid

Year 5: 5% x $10,000 = $500 Interest Paid + $10,000 Principal  ->  $10,500 Total for Year 5

At the end of the five-year contract, you had gained a total of $2,500 from interest payments, or a 25% total return ($2,500 gains / $10,000 principal).

As you can see, the above transactions were previously agreed-upon and both parties (you, the lender; and Laura, the borrower) knew what the outcome would be in advance. That is why bonds are fixed-income investments; because the returns that you get are fixed and known.

The above example explains the main way to make money from buying bonds, by collecting interest payments. To escalate this a little bit, we will go over the second way, capital appreciation of the bond. Investors can sell their bonds before they reach maturity, which creates a secondary market. This allows the value of the bonds to fluctuate before it expires (reaches the end of the contract). There are a lot of risk factors that make bond prices go up or down, which we will dive into in a future section.

The above are basic explanations of the risks that come with selling your bonds. However, keep in mind that, unless the company defaults on your bond (which is generally unlikely), you will receive a secured income periodically.

Remember, bonds are essentially loans. In your life, you will most likely come across a loan at some point, whether it is to buy a car or a house. In this case, you will be the borrower and the bank will be the lender. You borrow money and pay interest until the full value of the loan is paid off. When you enter into a loan, you are in debt; that is why bonds are commonly known as debt.

In the next section we’ll discover the main types of bonds and how their ratings work.

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