The following is adapted from Inheriting Chaos with Compassion.
When it comes to investing, most of us are familiar with stocks—an ownership share in a company—but you might be left wondering what a bond is and how it works.
Let’s look at what a bond is and how it can be used to grow wealth.
What is a Bond?
A bond is a loan to a company or institution. The investor purchases the bond at face value, and they receive a fixed interest rate on the loan. Interest payments are typically issued annually or broken into two payments per year.
The investor continues to receive these interest payments until the bond’s maturity date. At that point, the face value of the loan is paid back to the investor.
One of the largest borrowers is the US government, though companies can also issue bonds. In a low interest rate environment, bonds are a cheap way to fund an operation, especially if the company can grow faster than the interest rate on their loans.
Bonds are more stable than stocks because you know what the payoff is going to be. If you buy a bond that promises a 3 percent interest rate for ten years, you know exactly how much you’ll get in interest and the date of maturity when you’ll be fully repaid.
Market Interest Rates Fluctuate
While a bond’s interest rate is fixed at the time of purchase, market interest rates fluctuate over time. This means the market value of a particular bond also fluctuates if it was purchased at a higher or lower rate than the prevailing interest rate.
Let’s look at an example with a US government bond.
Imagine an investor buys a ten-year government bond for $10,000 at 5 percent interest. The interest rate is fixed, so for ten years, the investor will receive $500 per year in interest payments. If the interest rate drops to 3 percent a few years later, a new investor purchasing a similar $10,000 bond will also receive $500 per year, but would have to pay a higher price than face value to purchase the bond.
Both investors will receive their $10,000 back after the maturity date, but the first investor makes more money on the investment, because the second investor had to pay more than face value for the bond.
When investors decide to sell their bonds before the maturity date, the selling price is influenced by the current interest rate, as well as the fixed interest rate of the bond.
In our above example, the investor who owns the 5 percent bond would charge a premium because their bond is more valuable than the market rate. A buyer would then pay extra to receive the higher that current market interest payments for the rest of the life of the bond.
Conversely, if an investor wanted to sell a bond whose interest rate was below the prevailing interest rate, they would sell at a discount to make up for the lower value of the bond. The buyer would pay less for the bond, and receive lower interest payments than the current market rate, but they would still receive the full face value of the bond when it matures.
Using Bonds in Your Portfolio
The stability of bonds makes them an anchor for a portfolio. The downsides to bonds are that they’re less liquid (that is, converting them into cash quickly can be more difficult than with stocks), they grow at a slower rate than stocks, and the amount you receive back is fixed even if the company’s growth exceeds expectations.
The biggest risk with a bond is bankruptcy: should the company collapse and default on their loans, lenders won’t receive their money back.
This risk is rare, and it’s mitigated by rating agencies, such as the Standard & Poor’s Index and Moody’s Corporation, that determine the investment quality of bonds.
Bonds are rated on a scale from AAA (highest) to CCC (lowest). Bonds with a rating of BBB or lower are considered “junk bonds” that are below investment grade, meaning the company is not stable enough for their bond to be a reliable investment.
With reliable payoffs and low risk, bonds can help diversify your investment portfolio.
For more advice on bonds and other investment tools, you can find Inheriting Chaos with Compassion on Amazon.
Jennifer Luzzatto is a Chartered Financial Analyst®, a Certified Financial Planner®, and a NAPFA registered financial advisor. She began her career in financial services thirty years ago as a fixed-income trader in a regional brokerage firm and went on to manage personal trust accounts, institutional portfolios, and a municipal bond mutual fund at a commercial bank. In 1999, she founded Summit Financial Partners, transitioning from banking to financial planning and investment advisory services. Jennifer holds a BA in Psychology and an MBA from the University of Richmond. She lives in Richmond, Virginia, with her daughter and their dog.