Personal Finance 101: What Is a Bond?

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Amy writes in:

You often talk about investing in bonds. I don’t even understand what bonds are, let alone how to invest in them!

pf101Well, let’s start at the beginning.

What Is a Bond?
To put it simply, a bond is a way for an investor to buy a piece of someone’s debt, usually a government or a large company.

Here’s a clear example. Let’s say your city wants to raise money to put in some new roads. They don’t have enough money in their current budget to pay for it, but they’re quite able to put aside money in future budgets for the bridge.

The city’s solution? Issue bonds. They sell bonds to the general public for a certain price (the issue price) to raise money. Investors buy these bonds from the city, putting their money directly in the city’s coffers.

What does the bond buyer get? A bond states that on some regular basis, the person buying the bond will receive a certain small payment (known as the coupon). Then, when the bond matures, the person who bought the bond will receive the face amount of the bond.

So, here’s another example. Let’s say you buy a $10,000 bond from the city. It’s set to mature in ten years (meaning the city will give you back your $10K at that time). Until then, the bond states that you’ll receive a payment of $175 every six months – that’s the coupon rate.

Usually, bonds are issued by governments and large corporations to finance big purchases that they don’t have the cash on hand to pay for at that moment. But that’s a risk, right? What if they can’t make good on that payment? That’s why bonds come with bond ratings, which give an indication of how reliable the organization issuing the bond is. Some issuers are very secure (like the governments of first world nations), while others are much less secure (companies that are in poor financial shape) – the latter are usually called junk bonds and aren’t solid investments for laypeople.

Advantages of Bonds
The big advantage of buying bonds is that they’re reliable. The bond issuer is legally bound to make those regular payments to you and to pay you back the face value when the bond matures. The only real risk is the stability of the bond issuer, which is why many people not involved in financial careers stick to very safe issuers, like the federal government.

Thus, if you stick to big issuers like the federal government, they’re quite safe, too.

Another benefit of bonds is that some types of bonds (particularly municipal bonds – ones issued by cities for improvement projects) have tax advantages. Most municipal bonds are exempt from federal and state income tax.

Disadvantages of Bonds
So why would you not invest in bonds, if they’re so safe? Typically, very safe bonds don’t have a very strong return at all.

Take, for example, current returns on bonds issued by the U.S. government. Short term ones (3 month, 6 month, and 1 year treasuries) are paying no coupon rate at all, which means that all the government has to do to fulfill the bond is pay you back the face value at the end – no interest, no nothing. The only way to make money on these right now is to buy them a bit below their face value – thankfully, the government sells these at auction, which means that you can buy them just a bit below their face value (but still return less than 1%). Alternately, you can lock your money down for thirty years – but you’ll only get 3.5% of the amount you invest in annual payments, which isn’t great, either.

While this is an extreme example that’s only occurring because of the special economic times we live in, the basic idea is still true – bonds typically don’t earn great returns. What they do is earn safe returns.

Buying Bonds
So how can you buy bonds?

If you’re interested in buying them from the federal government, you can buy them directly via Treasury Direct. For many people who want to handle all of their own investing, this is a great way to buy individual bonds.

If you’re interested in municipal bonds, you’ll likely have to buy them through a brokerage. Some municipalities allow individuals to buy bonds directly from them, but minimum investments are usually well into the thousands.

If you want to buy other types of bonds (bonds issued by other governments or by corporations), you’ll likely have to use a brokerage for such purposes.

My recommendations are pretty simple. Either buy federal bonds directly from Treasury Direct, or buy a bond index fund from a reputable investment house, like Vanguard (the one I use). Going beyond this requires both a strong sense of risk and a lot of time to appropriately research your options.

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19 thoughts on “Personal Finance 101: What Is a Bond?

  1. I’m not in the market yet, but when I do become debt-free I’m tending to lean towards bonds. I just like the dependability and low risk. Being young, I know I’ll forgo the potential of better returns elsewhere. Who knows, I have a least a year or two to figure all that out!

  2. It’s really important to understand how bonds work – nicely done. Having said that, I’m really afraid of bonds now.

    As rates go up, bonds tank. Rates will likely go up over the next several years and if that happens, anyone who buys bonds will be a sad camper.

  3. Thank you for this informative post. I enjoy your blog very much and appreciate it!

  4. Nitpick here: T-bills (short-term US government bonds)have always been redeemed at par with no coupon. They make you money because you buy them at a discount to face value. This is not a result of the economic times–it’s just how those bonds are sold.

    The current extremely low yields on bonds, on the other hand, are a result of high demand due to the economic times.

  5. Don’t buy into bond mutual funds if you are looking for low risk investments. You are essentially paying a fund manager to buy (and sell) bonds that you, as an investor, can easily do for yourself.

    You also take the risk of the fund manager purchasing bonds that you would not because of the high risk of the entity borrowing the money. High risk equals high returns and with a high cost. For instance, research what General Motors bondholders are being forced to accept as the company flounders and what Orange County, CA investors experienced when the municipality when bankrupt back in 1994. Would you risk lending your money to such entities as they head into financial disaster? Your bond fund manager will risk your money, even if you wouldn’t.

    Also, as individual investors buy and sell their shares of the fund, the fund is forced to buy and sell bonds within the fund whether or not the market is favorable to the transaction. This is why bond funds perform worse when compared to buying and holding your own bond purchases, along with the implications of holding tax-exempt bonds within traditional versus Roth retirement vehicles.

    Purchase bonds yourself, hold them to maturity in tax appropriate accounts and avoid the inherent investment costs associated with a fund.

  6. Also, beware of corporate bonds with companies “too big to fail”; General Motors bondholders are staring at a ten cents on the dollar return (meaning they’ll likely lose 90% of their investment!)

  7. Lurker Carl hit on this a little bit, but bond index funds are not totally safe investments, because their share prices can fluctuate. Why is that? Well, suppose you buy a 30-year bond at 3.5%, and a few years down the road you need that money back. You can’t cash the bond in with the initial issuer, but you can sell it to somebody else. The thing is, if interest rates have gone up to 4.5% by then, nobody’s going to want to pay face value for your bond that’s only paying 3.5%, so its market value drops. Similarly, if interest rates drop to 2.5%, your bond’s value rises.

    Also, it would have been interesting to touch on the implications of bond interest rates to the national debt. People tend to freak out about the fact that the US government is taking on so much debt, because (I guess) they liken government debt to their own high-interest personal debt. But because bond interest rates are so low, the government can borrow money very, very cheaply, which can actually be a smart thing to do.

  8. Bonds are loans. The safety of a bond is no better than making a loan directly to someone. US Government bonds are generally considered the best because we don’t anticipate a revolution or government collapse similar to the former Soviet Union (199?), Iraq (2002), Iran (1980), etc.

    However, smaller government entities are less secure. Orange County, California, is but one example of a government entity defaulting on their bonds. WPPS (aka Whoops) was another instance. There have been others, less well-known, so you do take your chances when buying bonds.

  9. I think the comments on investing in a bond fund are off the mark. I don’t think that Trent was suggesting investing in bond fund that actively trades. He’s suggesting a low cost, passive index bond fund (like Vanguard), which is a much, much better solution than trying to pick individual bonds.

    First of all, picking individual bonds requires research to pick the right bond. Unless you’re just going to buy a safe bond (like from the US gov’t), you need to make sure that the issuing company isn’t going to go bankrupt before you’d get your money back.

    Second, investing in individual bonds often requires a lot of capital. Most bonds that I’ve seen (and I’m not an expert in bond investing) have a face value between $1,000-3,000. Whereas, you can invest in a bond index fund with much less.

    Paul

  10. Bonds may not be the best investment right now. While they are currently paying better than the banks, the interest rate risk is higher than normal now. With rates this historically low, they will have to go back up. When they do, the value of your bonds will go down. That is just how the math works. The coupon rate will stay the same, but the yield to maturity will adjust to market rates by impacting the market value of the bond.

  11. That was a great explaination. However, I am still confused on something; Is the bond fully matured to the face amount at year 30 or can you hold it longer and earn more interst, beyond the face amount?

  12. Hi,
    Can you please tell me how much tax reduction we’ll get if we buy bonds? Also, Is it same for both Government and Private bonds?

  13. Another point to be aware of is the call feature. If the bond is callable the borrower (company) can choose to pay you back at any time within the provisions of the bond. When market interest rates fall, companies rush to get out of the expensive bonds.

  14. Great all-in-post on how bonds work.
    A bit of a refresher for me, even though I went to business school.
    What about when interest rates are rising/falling?
    Might be good to add something on how the value can be affected.

  15. Unfortunately, if you buy a bond in General Motors, you will only get 30% of your money back despite bondholders’ status as 1st in line. The government’s plan only gives them 30%

  16. Great intro to the bond world and the advice is dead on what investors should be looking at – either individual through the treasury or a low cost index fund. Bonds are very complicated investments and the size of the bond market is many times larger than that of stocks. It’s important to remember to diversify among both credit quality and currency. When the dollar was weakening, international bonds performed extremely well with double digit returns.

    @Baker

    Be careful about going too far into the bond world. They paid a little above inflation over the last 40 years while stocks have done markedly better averaging 4% to 7% above inflation. I would argue that over the long-term (25 years or more), stocks are safer than bonds in light of the effects of inflation and erosion of purchasing power.

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