Ever wondered, "What are bonds and how do they work?" We were sent this primer from the people at United Capital, which we think lays the groundwork really well.
Many times in my career I have launched into detailed discussions of the economy, interest rates and how they affect bondholders. Often when I finish, someone will turn to me and ask, “Umm, Steve, what is a bond?” That’s when I realise that most people are not all that familiar with how bonds actually work. If you are one of them, this short piece is for you.
To begin, there are only two types of investments: either you own something or you lend money. With stocks, you are an owner and with bonds, you are a lender.
As a lender, you can expect two things: you expect your money back at some future date and you can expect to receive a fair rate of interest during that period. The shorter the lending term, the lower the interest rate; the longer the term, the higher the rate.
The interest earned is most often a fixed percentage—2%, 3%, 8%, and so on. The rate of interest is determined not only by the length of the term but by the ability of the borrower to pay you back and the level of interest rates in the general economy. The better the borrower’s credit, the lower the rate of interest you will receive. As with a credit card, you would expect to pay less if you had good credit and more if your credit was poor. The lender feels the same way. As a bondholder, remember, you are the lender.
Let’s take it a step further. Imagine that you lent money to two of your friends. The first friend’s loan was for two years at 2% and the other for 30 years at 5%. Let’s imagine how you would feel if, in the following six months, interest rates in the general economy doubled for all new investments of the same type. In other words, 2% rose to 4% and 5% rose to 10%.
How disappointed would you be with the rates you originally charged? With the two-year loan, probably not so much because you’re getting your money back shortly enabling you to reinvest at the higher rates.
On the other hand, the 30-year loan would likely be a significant disappointment. The $10,000 you loaned, which is paying you $500 per year (5%), could have paid you $1,000 per year (10%) if only you had known that rates were going to rise. Alas, it’s too late because you are now committed to receiving $500 per year for 30 years. Ouch!
What if you said, “Hey, maybe I can sell this loan [let’s call it a bond, now] to someone else and use that money to buy the new bond earning 10%?” As good as that sounds, it wouldn’t work because, frankly, who would buy your bond at 5% if they could get 10% elsewhere?
In the real world, your $10,000 bond would fall in price to $5,000, thereby allowing someone to buy two of your bonds to get their 10%.
The takeaway? If interest rates rise during your ownership of the bond, the bond price will fall. How much will it fall? With the two-year example, not so much since you’re getting your initial investment back quickly. The 30-year bond will drop considerably more to match the going rate.
Just a note, so bonds don’t get a totally bad reputation. If interest rates fall, bond prices rise, so you can actually MAKE extra money if interest rates go down.
Keep in mind that the market value of your bond does not affect the interest you receive or the return of your original investment in the future; it only affects the money you would receive if you had sold.
1. Bonds are loans.
2. The interest rate is based on the maturity of the bond, the credit of the borrower, and the level of interest rates in the general economy.
3. The risk? Your borrower’s ability to pay you back and the situation in which you’ll find yourself if the bond’s maturity is long-term and rates rise in the meantime.
Of course, there are numerous other factors at play in the world of bonds, but this is a good start.