Investing 101: 3 Things You Should Know about Bonds

The following post was originally published on Debt Free Guys

This is our fourth post in our Investing 101 series. See the whole series here.  types. 51 percent of Americans didn’t save for retirement in 2014. Their reason for not investing? They didn’t know enough about investing to invest. We hope to help fix that with this series.

So far, we’ve discussed stocks, mutual funds and Exchange Traded Funds (ETFs). This week, we’ll discuss bonds. Next week we’ll discuss cash equivalents.

1. What are Bonds?

Bonds are debt instruments that let investors lend money to a government, government agency, municipality or corporation to fund various projects or programs. The investor is known as the bond holder or simply investor. The government, government agency, municipality or corporation is known as the bond issuer.

The investor lends money to the issuer. In return, the issuer provides the investor with a bond. The bond comes with a specified rate of interest (yield) during the life of the bond (or term) and the commitment to repay the face value of the bond (principal) when it matures or comes due on an agreed upon due date.

This is no different than loaning money to a friend or family member when you negotiate the detail of the loan, such as amount, length and interest rate, if any. A bond is a legal IOU.

These IOUs, however, trade on bond exchanges, similar to stocks and ETFs, and may change hands several times during the life of the IOU.

2. What Types of Bonds Are There?

For simplicity’s sake, we’ll cover the two major types of bonds, government and corporate. There is a third type of bond called zero-coupon bond. Most of what we say below will have an exception and most of those exceptions are applicable to zero-coupon bonds.

Government Bonds

Government bonds fall under two categories depending from which area of the government they’re issued. Bonds issued by the U.S./Federal Government are typically called treasuries. There are three types of treasuries, bills, notes and bonds.

The difference in the types of treasures is contingent on their term length. Bills mature in less than one year. Notes mature between one and ten years and bonds mature in more than ten years.

The benefit of U.S. government bonds is that they are backed by the “full faith and credit of the U.S. government”. This means they typically carry little risk because if the government runs out of money it can raise taxes to refund principal amounts paid by bond holders.

Other governments offer bonds. The bonds of other governments carry different risk. For example, U.S. government bonds are significantly safer than Greek bonds right now. U.S. government bonds right now typically offer lower yields for comparatively similar Greek bonds because of the higher risk of today’s Greek bonds.

Also under the category of government bonds are municipal bonds or bonds offered by cities. Municipal bonds are slightly riskier than U.S. government bonds, but less risky than corporate bonds. Cities, such as Detroit for example, have defaulted. Municipal bonds are not taxed by the Federal government and are often not taxed by the city or state from which they are issued.

Typically the shorter the term of a bond, the lower its yield. This is because the bond holder takes on less risk. The longer the term, the higher the yield it typically offers. This is because the longer the term, the greater chance of some unforeseen circumstance preventing the issuer from repaying the principal amount.

Corporate Bonds

Any company can issue bonds to raise capital for corporate investments or projects. There are a number of contingencies that can be put on corporate bonds, but typically corporate bonds are broken down by their yield.

Because corporations have a higher risk of default than governments, they typically offer higher yields. Therefore, a bondholder must determine the amount of risk they’re willing to take on relative to a bond’s yield.

3. What Are the Rewards and Risks of Owning Bonds?

The reward of owning a bond is that its investment risk is typically lower than the risk of a common stock because if a government, government agency, municipality or corporation goes bankrupt, bond holders are the first in line to get their money back. As investors age or near retirement, they typically reduce stock exposure and increase bond exposure. This migration typically reduces the investors portfolio volatility and risk of loss.

That safety is a double-edged sword, though. An investment or portfolio that is too safe can yield little return, all or most of which can be wiped away due to inflation. This is called inflation risk.

Bond holders must also be concerned with interest rate risk. Interest rate risk is the risk affected by changes in The Federal Reserves adjustments to the over-night lending rate. For the last six years, this has been near-zero percent and, therefore, bond holders have not earned high yields. Because the bond market isn’t as liquid as the stock market, meaning there aren’t as many buyers and sellers, bond holders can find it difficult to trade low yield bonds for high yield bonds.

Another risk, but certainly not the last, is default risk. As with loaning money to anyone, the greatest risk you take on is that your loan won’t be returned. Credit worthiness or the risk of lending to a government, government agency, municipality or corporation is measured by three companies, Standard & Poor’s, Fitch and Moody’s.

All bond issuers carry default risk. In 2011, Standard & Poor’s downgraded the U.S. Government’s credit rating because of the large amount of debt carried by the U.S. Government and the risk it may not be able to repay loans. No investment is risk free.

That’s what you need to know about Bonds. With this basic understanding now of stocks, mutual funds, ETFs and bonds, you have a greater knowledge of investment types than most Americans.

Next week, we’ll discuss cash equivalents.

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