A Form of Lending
Many individuals invest their extra money in a savings accounts, interest bearing checking or money market accounts, or certificates of deposit (CDs) with their local bank or credit union. When it comes to saving and investing, this is the starting reference point for many. While many individuals believe they put their savings in the bank and it just sits there generating interest, this is not what actually happens. Banks use the funds toward their operations—generating an IOU to the depositor—so the individual is essentially lending money to a bank.
Lending money to your local bank is not your only option. There are other institutions that borrow in the financial markets and they typically pay you a higher rate of interest. Some of them are are also safer than your local bank. Governments (local, state, and federal), government agencies (e.g., the Federal National Mortgage Association - “Fannie Mae”), corporations, and financial institutions raise money by selling bonds. In fact, the bond market is the largest market in the United States.
Whether you are putting money in a bank savings account or buying bonds sold by Microsoft that mature in 10 years, you are lending money. This is different than buying stock. When you buy shares of stock you become an owner of the company. In the financial markets of our (partial) system of capitalism, there are essentially 3 things you can do with your money to try to increase it: lend it, buy shares of a business, or buy tangible property (e.g., silver coins or real estate). Bonds are a major component of your option to lend your money.
There are many synonyms for bonds in the investment world. They are often referred to as credit, debt, or fixed income. If nothing else, these various names help investors understand what bonds are by reflecting their attributes. If you participate in a 401(k) plan you may own a corporate debt fund, a short-term fixed income fund, or an intermediate credit fund. Regardless of the name, they are all bond funds, and in all circumstances, through them, you are lending money to various entities.
Most of you reading this likely own bonds already as an investment, either directly or indirectly. Investors commonly hold bond mutual funds in a retirement plan or are recipients of a pension plan that invests a substantial portion of its assets in bonds. One way or another, bonds have at least some affect on the financial life of almost everyone. In this segment, we are going to begin with the basics of bonds—what they are and how they work.
The Mechanics of Bonds
A bond is an investment in which an investor lends money to a corporation, government, or government agency for a specific period of time. The investor (the lender) receives periodic interest payments over the life of the bond (the loan) from the borrower, and when it matures, he receives the principal amount back. If you own a bond fund, you own shares of an investment company that owns a pool of bonds. The greatest advantage of a bond fund is that it diversifies your risk. If the fund owns 200 bonds and 1 defaults this will have a minimal impact for fund shareholders. If you put all your money in the bonds of one company and it defaults, then you could potentially lose everything depending upon whether or not the bonds are secured or unsecured (backed by company assets).
Important take home point #1 is thus:
When you invest in bonds you are lending money to a corporation, government, or government agency.
This point should dispel all notions of bonds always being a safe investment.
Another important question comes up, “If I am lending money, at what interest rate should I lend it?” That question should be answered after analyzing 3 key considerations.
- What is the creditworthiness of the entity that wants to borrow from me? In other words, what is the risk that they will not be able to pay me the promised interest and/or return my principal at the end of the loan (i.e., default on their obligations)?
- For how long should I lend the money? And, should they pay me a higher rate of interest as the length of the loan is increased? One’s view of future inflation and interest rates trends underpins this assessment. If you think future inflation will be higher, than you would be wise to require a higher rate of interest to compensate for it.
- When considering what interest rate to lend at, one must look at other available investment options. The better the other options, the higher the interest rate one should require to lend money.
Investors weighing these considerations combine in the marketplace to price bonds.
Generally, when a bond is issued (first sold), it is issued with a coupon rate and pays interest twice a year. For example, if you buy a 10-year U.S. Treasury Bond for $1,000 and it has a 4% coupon rate you will receive two coupon payments a year for $20 ($20 x 2 = $40 / $1,000 = 4%). When the bond matures (after 10 years) you will receive your final interest payment and the principal ($1,000) back. See Figure 1 below for an additional example.
During the life of a bond it can be sold (traded) to other investors. Bonds trade on exchanges just like stocks, and this where things get a bit more confusing.
Although bonds usually have a $1,000 face value, they are priced at 1/10 of their face value. 1 newly issued bond will raise $1,000 worth of capital for the borrower, but it will be priced at $100. Expressed differently, 1 bond priced at $100 is actually worth $1,000. Corporate bonds subsequently trade in the markets in increments of 1/8, such as 101.375 (for 101 3/8), whereas treasury bonds trade in increments of 1/32, such as 97.15625 (for 97 5/32).
A bond’s stated coupon rate is paid on the face value. If you own a 4% coupon bond and you bought it at face value ($100), then your annual return would be 4% each year until the bond matures. If, however, you buy a 4% coupon bond that matures in 4 years but is trading at a discount of 96, then your total return would include an additional $40 because the bond you paid 96 for will be worth 100 at maturity. You will get the 4% coupon rate each year ($40 x 4 years = $160) plus a $40 capital gain on the appreciation of the bond price.
The yield-to-maturity calculation is commonly used for bonds to make them easier to evaluate. Yield-to-maturity is the total return on a bond held to maturity. It is expressed as an annual rate. In the previous example (4% coupon maturing in 4 years priced at 96), the yield-to-maturity is 5.12%.
Bond Prices Move in the Opposite Direction of Yields
The most critical thing to understand about bonds when it comes to investing is that bond prices and yields move in the opposite direction.
Investors demanding a higher yield will sell bonds, driving their prices down until enough buyers step in to balance the market. What makes the buyers step in? Higher yields. In our previous example, the bonds that were originally priced at $100 and yielded 4%, were sold down to 96 where they then yielded 5.12%.
Conversely, investors who think bonds are a good buy at the current yield will buy bonds, driving their prices up until enough sellers come forth to balance the market. What makes the sellers come forth? Lower yields. Bondholders may sell and realize gains if they see better opportunities elsewhere (e.g., high dividend paying stocks).
This interplay between bond prices & yields goes on every business day in the bond market, setting prices based upon investor views of economic conditions, inflation, and other interest rate variables.
This concept is so vital to understand that it is helping thinking about it from another angle.
If bond prices are rising, interest rates are falling, because people are willing to lend at lower interest rates. If bond prices are falling, interest rates are rising, because lenders are demanding higher interest rates.
To make sure this relationship between bond prices and yields is clear, let us look at another example. Consider a 5% coupon bond with 5 years to maturity.
5% coupon bond with 5 years to maturity
- When selling for $100 the yield to maturity is 5%
- If selling for $105 the yield-to-maturity would be 3.89%
- If selling for $95 the yield-to-maturity would be 6.18%
A 5% coupon bond could sell for more or less than $100. Why would it sell for more? Because, given other options, such as similar bonds yielding only 3.5%, investors may be willing to pay more for it to receive the remaining annual coupon payments of $50. In this case, the actual yield the new owner of the bond receives would be less than 5%. If he buys if for $105, then his yield-to-maturity would be 3.89%.
Why would the 5% coupon bond sell for less than $100? Because, given other options, such as similar bonds yielding 6%, investors would not be willing to pay as much for it because the remaining annual coupon payments are only $50 verses the $60 of annual return available from other bonds. As the price of the bond falls, the investor will receive a higher yield. He may be willing to buy it for $95 because his yield-to-maturity would then be 6.18%.
Important take home point #2 is thus:
Bond prices move in the opposite direction of bond yields. When there is stronger demand for bonds (more buyers than sellers), prices will rise and yields will fall (buyers are willing to accept lower yields). When there is weaker demand for bonds (more sellers than buyers), prices will fall and yields will rise (buyers are demanding higher yields).
Factors stemming from central bank monetary policies and economic conditions driving interest rates higher will cause bond prices to fall. These same factors driving interest rates lower will cause bond prices to rise.
Questions? Please comment below.
Joshua S. Hall, ChFC