Investing 101: All About Bonds

BondsAs we continue our series on the basics of investing, we next turn our attention to bonds.

In my opinion, bonds get a bit of a bad rap in the FIRE community.

Bonds can be a bit more complicated and more challenging for an individual investor to purchase than bank products, and may not generate the same returns as stocks, but I think bonds can still play an important role in many portfolios.

As a general rule, bonds fit in between bank products and stocks when considering risk and reward. Over the long run, you will probably earn more by investing in bonds than in bank products, while also taking more risk. Over the long run, you will probably earn less by investing in bonds than in stocks, while also taking less risk.

That said, there are exceptions to every rule. Investing in certain high yield bonds or distressed debt can be extremely risky – but also potentially offer significant rewards.

Bonds come in a variety of shapes and sizes (which we will get into shortly), but at their essence are fairly simple securities (at least before the investment bankers start making them more complicated!).

When you purchase a bond, you are lending money to a borrower today, with the expectation they will pay you periodic interest (called the coupon) over the term of the investment, and then return the money you invested (called the principal) back to you at an agreed upon date in the future (called the maturity date).

For example, let’s say Apple Inc. decides to issue a new bond to raise money to manufacture more iSomethings. The company offers a 5-year bond with an interest rate of, say, 2.5%. If you invest $1,000 in this new Apple bond today, the company promises to pay you $25 a year in interest ($1,000 times 2.5%) for the next five years, and then to give you back your $1,000 at maturity.

Bonds can be issued by a variety of entities, such as the federal government, state governments, municipalities, and corporations. Bonds that are viewed as higher quality, such as those issued by the U.S. government or large multinational companies like Apple, will generally offer lower interest rates to potential investors than high yield bonds, which are riskier investments.

With any bond there is a risk the borrower will not make the scheduled interest payments, and that your principal will not be returned at maturity. Moreover, if you have to sell your bond before its scheduled maturity, it could be worth more, or less, than you paid for it. The majority of bonds are riskier than typical bank products, such as savings accounts and CDs.

Types of Bonds

As mentioned above, many different entities issue bonds. We’ll highlight some of the major types of bond issuers in the United States in this section.

Financial IndependenceUnited States Treasury Securities (U.S. Treasuries)

Treasuries are issued by the federal government to raise the money needed to fund the activities of the government, and pay off maturing Treasuries that were issued in the past. Treasury securities come in three varieties:

  • Treasury Bills (T-Bills) are short-term securities issued with maturities of 52 weeks or less. Unlike most of the bonds we will be discussing, T-Bills are zero-coupon bonds, meaning you don’t actually receive an interest payment while you own the security. Instead, you purchase a T-Bill at a discount, which is a price less than the par amount (or face value) you’ll receive at maturity. For example, you might purchase a 26 week T-Bill with a face value of $1,000. Because you aren’t going to receive a coupon from this zero-coupon bond, you’ll be able to purchase it at a discount, a price below the par value, say $990. The $10 difference between the discount price and the par value you will receive at maturity represents the interest you earn for lending your money to the government.
  • Treasury Notes are bonds issued by the federal government with maturities of two, three, five, seven, or ten years. Interest on treasury notes is paid semi-annually (twice a year), with your principal paid back at maturity. For example, you might purchase a ten-year treasury note with a face value of $1,000 and a coupon rate of 2%. You will receive an interest payment of $10 every six months ($20, or 2% of your principal, a year), and your $1,000 in principal will be returned after a decade.
  • Treasury Bonds are treasuries issued with a maturity of 30 years. Like Treasury Notes, Treasury Bonds pay interest semi-annually and return your principal at maturity.

Treasuries are viewed as among the least risky fixed income investments, as they are backed by the “full faith and credit” of the U.S. Government. Interest income on Treasuries is subject to federal income tax, but exempt from state or local taxes. Treasuries can be purchased through a brokerage account, or directly from the government via the Treasury Direct program.

Municipal Securities (Munis)

Munis are bonds issued by states, municipalities, counties, and other governmental entities to finance public projects, such as building schools, roads, sewers, airports, etc.

The variety of municipal securities is almost endless. For example, issuers in the muni market could include entities such as the State of California, the New York State Thruway Authority, the city of St. Paul, Minnesota, or a school district in Dallas, Texas.

There are two primary types of municipal bonds. General obligation (GO) bonds are not backed by revenue from a specific project. Rather, the principal and interest payments of GO bonds are supported by the taxing authority of the issuer. Revenue bonds, on the other hand, are supported by the income generated by a specific infrastructure project, such as a toll road.

Municipal bonds are popular with some investors because of their potential tax advantages. Interest on most municipal bonds is exempt from federal taxes, and if you live in a state or other municipality that issues muni debt, interest you earn on those securities may be exempt from state or local taxation. There are also pockets of the municipal bond market that issue taxable securities, which are not tax exempt. Before investing in municipal bonds, you should check with a professional tax and/or financial advisor to make sure you fully understand the tax implications of your potential investment.

Corporate Bonds (Corporates)

Corporate bonds are, in my opinion, among the simpler fixed income securities to understand. Many corporates are issued by large public companies that some of us do business with every day, such as Apple Inc., Exxon Mobil Corporation, General Electric Company, The Procter & Gamble Company, and Wal-Mart Stores, Inc.

Corporations issue debt for a variety of reasons, such as funding business operations, making acquisitions, purchasing inventory, buying equipment, or funding share repurchases and dividend payments. Interest payments on corporate bonds are typically made twice a year, and principal is repaid on the scheduled maturity date.

You might be wondering about the differences between investing in the bonds or the stock of a specific company. When you purchase a corporate bond, you are lending money to the company, which will be paid back at maturity if the company has the necessary financial resources. When you purchase a share of stock in a company, you are buying a very tiny ownership interest in the company. In the event a company runs into financial difficulties, and eventually goes through a corporate restructuring or files for bankruptcy, bondholders typically have a more preferential claim on the company’s assets. This means that normally, bondholders will get paid before stockholders if the company has difficulty meeting its financial obligations. In general, investing in a bond of a company is less risky than investing in its stock. Because of this, the potential returns associated with investing in a bond of a company are typically less than the potential upside associated with investing in its stock.

Corporate bonds are issued with a variety of maturities. Some companies issue commercial paper, which typically has a maturity of 270 days or less. Similar to Treasuries, corporate bonds are also frequently issued with maturities from two to thirty years. Some well-known companies like Walt Disney and Coca Cola have issued even longer debt, with scheduled maturities of 100 years (these are known colloquially as century bonds).

Mortgage-Backed Securities (MBS)

Early RetirementMBS are issued by a wide variety of entities, from U.S. federal government agencies, to government sponsored enterprises (GSEs), to private financial institutions, such as investment banks. MBS are secured by a pool of mortgages on homes or other real estate. When you purchase a mortgage-backed security, you are essentially lending money to home buyers or other real estate investors.

MBS come in a variety of shapes and sizes. Mortgage-backed bonds issued by U.S. federal government agencies, such as Government National Mortgage Association (Ginnie Mae), are typically backed by the full faith and credit of the U.S. government, similar to U.S. Treasuries. However, mortgage-backed bonds issued by GSEs, such as Federal National Mortgage Association (Fannie Mae), or private firms, are not backed in the same way. There are MBS comprised of mortgages on residential properties (RMBS), as well as MBS comprised of mortgages on commercial properties (CMBS). Please make sure you understand what you are thinking about buying before making a purchase!

In contrast to many of the other fixed income securities we have discussed, MBS don’t typically pay interest semi-annually and principal at maturity. Because most mortgages are paid monthly, MBS typically pay interest on a monthly basis. Moreover, most MBS pay back an increasing portion of your principal every month. Because of this, you won’t receive a lump-sum payment of your principal when your MBS matures, and the payment you receive each month may vary as the underlying mortgage borrowers pay off their loans at different rates as interest rates and the economic environment change. If you are investing in bonds to generate a certain amount of income every month, or because you want to receive your principal back in a lump sum at a specific time, the vagaries of the MBS market may not be for you!

While there are many other types of bonds we may discuss in the future, for purposes of our introduction to the topic, we’ll stop here and move onto some other important things to know before you consider investing in fixed income securities.

Credit Ratings

Because of the wide variety of bonds available, and the fact there can be literally dozens of new bonds issued on any given day, it can be difficult for many investors, even professionals, to know everything about each potential investment in the fixed income market. To assist investors, the creditworthiness of many bonds is evaluated by credit rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings. While credit ratings can help identify potential investments that might help you move closer to financial independence and early retirement, keep in mind the credit rating agencies are typically paid by the entity that is seeking a credit rating for its bond, rather than investors. 

Credit Ratings
Credit Ratings Framework from S&P, Moody’s, and Fitch, with the highest quality ratings at the top.

That said, credit ratings do provide a rough framework for quickly assessing the potential ability of a bond issuer to regularly make its interest payments and eventually pay back principal. Over a period of decades, bond issuers with higher credit ratings from firms like S&P and Moody’s have defaulted on their obligations less frequently than those with lower credit ratings.

As you would expect, bonds with higher credit ratings typically pay investors less than those with lower credit ratings, because of the additional default risk associated with the lower-quality bonds. Bonds with investment grade ratings historically have lower default risk than high yield, or junk, bonds.

In addition to credit ratings, the agencies also typically offer an outlook on the credit, such as Positive, Stable, or Negative. Credit outlooks provide some additional information about possible future improvement or deterioration in the underlying credit quality of the potential investment. Credit ratings and outlooks are revised by the rating agencies as the underlying fundamentals of each company, municipality, or other bond issuer evolve, issuers and competitors make strategic decisions, and the broader financial markets and economy change.

Credit Spreads

Investing in any bond involves risk. One way investors attempt to quantify this risk is by considering how much additional yield they can earn by investing in a bond, such as a corporate or muni, relative to investing in a U.S. Treasury security. Credit spread is the difference between the yield on a U.S. Treasury and the yield on another fixed income investment.

Corporate Bonds
Approximate yields by rating in the U.S. Corporate Bond Market as of October 2017.

For example, let’s assume the ten-year U.S. Treasury note is priced at a yield of 2%. A ten-year bond from a very high quality investment grade corporate bond issuer, such as healthcare and consumer giant Johnson & Johnson, might be priced at 2.75%. The 0.75% difference between the yield on the U.S. Treasury and the Johnson & Johnson bond represents the credit spread between the two potential investments. When discussing credit spreads, bond investors usually talk in terms of basis points (bps), rather than percentages. One basis point equals 1/100th of a percent, so the 0.75% difference represents a credit spread of 75 bps.

In contrast, a ten-year bond from a smaller, more highly leveraged, high yield corporate bond issuer, such as gaming technology provider Scientific Games Corporation, might be priced to yield 8%. That would represent a credit spread of 600 bps.

Bond Math and Bond Pricing

Just like stocks, the prices of bonds (and underlying credit spreads and yields) change in the financial markets every day as the interest rate environment, economic environment, perceptions about the underlying credit quality of bond issuers, and a multitude of other factors change.

Most bonds are issued at (or very close to) what is called par value or face value. Face value is often $1,000.

Let’s look at a quick example. Assume that AT&T Inc. issued a new ten-year bond at par to yield 4%. Face value is $1,000. If you purchase $1,000 of the bond, you would expect to earn $40 in interest (4% times $1,000) for each of the next ten years (paid $20 semi-annually) and then have your $1,000 in principal repaid in a decade. To review our discussion of credit spreads, if the ten-year U.S. Treasury was priced to yield 2.50% when you purchased the AT&T bond, you would have bought the bond at a spread of 150 bps.

However, as interest rates and company fundamentals change, the prices of bonds also change.

Let’s assume the day after you purchased your AT&T bond, overall interest rates declined, and the perceived credit quality of AT&T improved dramatically. If the ten-year U.S. Treasury is now priced at 2%, and investors demanded a credit spread of just 100 bp to invest in AT&T, a new ten-year bond from AT&T would price at a yield of 3%.

If the bond market requires a yield of just 3% to invest in AT&T at par, and you have an AT&T bond yielding 4%, the bond you own is suddenly a very valuable asset. To yield 3%, the price of your $1,000 par value AT&T bond with a 4% coupon would have to increase to $1,333 (the $40 a year in interest your AT&T bond provides, divided by the 3% market rate for AT&T, gives us the new price of $1,333). A bond priced above its par value is called a premium bond.

Of course, bond math works in the opposite way as well. If the day after you purchased your AT&T bond, the yield on the ten-year U.S. Treasury climbed to 3%, and credit spreads on AT&T widened to 200 bp, the company would have to pay 5% to issue a new bond at par. In this situation, the 4% yield you are earning on your AT&T bond is suddenly very unattractive relative to the market. Nobody is going to pay par value for your 4% AT&T bond when they can purchase a new bond at par with a coupon of 5%. The price on your bond is going to fall to around $800 (your bond provides $40 a year in interest, divided by the 5% market rate for AT&T, giving us a price of $800 to provide the yield the market is now requiring). A bond priced below its par value is called a discount bond.

While my examples were extreme, as a general rule, interest rates and bond prices move in opposite directions. If interest rates fall, existing bond prices rise. And if interest rates rise, existing bond prices fall.

When investing in bonds, you need to keep in mind that if you have to sell the bond before its scheduled maturity, you may get more, or less, than the amount you paid for it. Many individual bonds offer less liquidity than publicly traded stocks listed on the New York Stock Exchange or NASDAQ markets, so there are also no guarantees you will be able to transact in your brokerage account at the exact time and price you desire if you have to sell before maturity.

Indentures and Covenants

Corporate BondAs you have probably noticed, bonds can be complicated investments. Fortunately, there are very specific agreements between bond issuers and bond investors that attempt to explain all the terms and conditions associated with a specific bond issue.

A bond indenture is contract between the bond issuer and the bondholder that describes all of the key features of the bond, including its scheduled maturity date, coupon rate, timing of interest payments, potential redemption provisions, and other terms and conditions of the agreement. The indenture may also include specific bond covenants, which, for instance, might limit the issuer’s ability to take on additional debt, require the issuer to maintain investment grade credit ratings, or regularly provide audited financial statements to investors.

You should never invest in a bond without reviewing the indenture first. The terms and conditions can vary significantly, even among different bond issues from the same issuer!

My Experience With Bonds

As someone in his mid-40s hoping to achieve financial independence before turning 50, bonds are beginning to play a more important role in my investment portfolio.

I have dabbled with investments in bonds over the past 25 years, keeping a small portion of my retirement accounts in bond mutual funds for potential diversification purposes.

Following the global financial crisis, I began investing in individual corporate bonds through my Fidelity brokerage account. I was able to purchase bonds of several investment grade companies at deep discounts from late 2008 through 2011, and continue to hold a few of those investments today at very attractive book yields. Unfortunately, most of the bonds I bought back then are maturing over the next couple of years, so I will have to reinvest the proceeds at today’s lower yields if I decide to keep that money in the bond market.

As I attempt to increase my passive income as I get closer to early retirement, I continue to purchase an occasional corporate bond to supplement anticipated earnings generated by dividend stocks. Because scheduled interest payments on bonds are contractual, while dividends on stock are discretionary, I like the idea of having both in my portfolio. I am also starting to look more closely at the scheduled maturities of the bonds I own, and trying to ladder those maturities over the next ten to fifteen years to help fund potential future expenses before we begin tapping into our retirement accounts or are eligible for Social Security.

That said, the vast majority of our investment portfolio remains in stocks. Returns from the stock market should be higher than returns from investing in bonds over the long term, and we want to do everything possible to maximize our returns, given our goal of a longer than average retirement!

Summary of Investing In Bonds

My sincere thanks to readers who have stayed with me this long!

I know bonds can be a dense topic, but quite honestly, we have only scratched the surface on this subject. I haven’t mentioned a multitude of other aspects of the bond market, such as prioritization of different debt instruments (secured vs. unsecured vs. subordinated debt), floating rate notes, callable bonds, convertible bonds, yield curves, and hundreds of other idiosyncrasies of the fixed income markets. Hopefully we can go much deeper on bonds over the coming years as we continue down our path towards financial independence!

As a general rule, bonds fit in between bank products and stocks when considering risk and reward. Over the long run, you will probably earn more by investing in bonds than in bank products, while also taking more risk. Over the long run, you will probably earn less by investing in bonds than in stocks, while also taking less risk.

Next time around, we’ll discuss investing in stocks.

Retiring On My Terms is for informational and entertainment purposes only. We are not financial advisors. You are responsible for your own decisions. Before making any financial decisions, you should consider your own financial circumstances, and consult with a professional advisor.

What percentage of your portfolio do you keep in bonds? Do you plan on increasing or decreasing that amount over the next year? Why?

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