When the government or a corporation wants to raise money, they often issue bonds. Bonds are essentially a type of loan. When you buy a bond, you are lending money to the organization that issued it. In return, the issuer pays you interest every year and then repays the loan amount when the bond matures. Much like stocks, bonds are bought and sold through bond markets. They are usually sold in increments of $1,000.
A bond market is a financial marketplace where bonds are bought and sold. Unlike a stock market, there are no central exchanges, like NASDAQ or the New York Stock Exchange.
Primary and Secondary Bond Markets
Bond markets are usually divided into two types. The primary bond market is used by companies when they issue a bond. The company typically offers the bond through an investment bank, which finds buyers, sells the bonds and earns a commission for each sale.
Once the bond has been sold, anyone who bought it can then sell it again through a secondary bond market. This is where most bonds are traded and where most investors buy their bonds. Often, financial institutions will buy bonds in bulk from the primary market and then resell them in the secondary bond market. Bonds sold on the secondary market are generally more expensive because those who are selling them want to make a profit and the brokers handling the deals charge transaction fees over and above the cost of the bond.
Terms to Know When Buying Bonds
Before investing in bonds, there are several terms you should know:
- The price you pay for a bond is called the face value or par value.
- The interest paid to you is called the coupon.
- If you buy a bond for its face value, it was sold at par.
- If you pay more than the face value for a bond, it was sold at a premium.
- If you pay less than the bond’s face value, it was sold at a discount.
- The rate of return you get for each dollar invested in a bond is called the yield rate. Before buying a bond, there are two yield rates you should examine.
- The yield to maturity rate is the amount you will make when the bond matures, including any difference between what you paid for the bond and its maturity value.
- The yield to call rate is what you will make if the bond is called by the issuer before it matures.
What Are the Three Main Types of Bonds?
All bonds are issued for one of two reasons: to raise money for specific projects or to raise money for day-to-day operations. For example, if a company wants to expand into new markets and needs to build a new factory, the company may issue bonds. If a hospital needs a new wing, the local government may issue a bond to pay for that.
The three main types of bonds are government bonds, municipal bonds and corporate bonds.
If you’re looking for a low-risk investment, U.S. Treasuries should be attractive, as they are issued and backed by the U.S. government. The U.S. Treasury offers bonds, notes and treasury bills. Treasury bills or T-bills, mature in 12 months or less and are purchased at a discount from their face value. Treasury bonds and notes pay a fixed interest rate every six months until they mature. Treasury notes mature in one-to-10 years, while bonds are for periods longer than 10 years. Both are purchased for about their face value. Treasury bonds, like other U.S. Treasury investments, are exempt from state taxes.
Municipal bonds are issued by local governments and local public bodies like cities, towns and school boards. The money can be used for things like public works projects, schools or hospital funding. Interest earned from these bonds is exempt from federal tax and are often exempt from state tax. However, if you sell a municipal bond, any capital gains you earn from that sale are subject to tax.
Corporate bonds are issued by corporations looking to raise money. They are higher risk than those issued by the government. Bonds can be issued for periods of one year or more. They often provide you with higher interest rates, however, that interest is subject to tax. In most cases, they are offered in $1,000 increments and mature anywhere from one-to-30 years. When you purchase stocks, you own a portion of the company, however, this is not the case with bonds. Some corporate bonds can be risky, depending on the company issuing them. Services like Standard & Poor and Moody’s Investors Service provide investors with credit ratings for corporations and the bonds they issue. Bonds with a good rating are called investment-grade. Bonds with a lower rating are riskier investments.
How Do You Make Money With Bonds?
There are three ways you can make money with a bond. One way is simply to buy the bond and then collect the annual interest until the bond matures. The second way is to sell the bond for more than you paid for it. The third way is to buy the bond for less than it will pay you when it matures.
A major component of a bond's value is its coupon rate – the interest rate you are paid on a bond. The coupon rate is normally expressed as a percentage. For example, on a bond with a face value of $1,000, a 4-percent coupon means you would get $40 of interest paid to you each year.
Interest rates fluctuate, and there is no way to be certain if the rates you might get today will be better or worse than those you could get next year. To manage risk and reward, many investors use a strategy called laddering when buying bonds. Instead of buying bonds that all mature at the same time, they will purchase bonds that will mature in different years. For example, if you are planning to retire in 20 years, you could buy bonds that are due to mature in 10-to-20 years or buy 10-year bonds every year over the next 10 years.
To further spread out the risk, you can combine laddering with a rollover strategy. As each bond matures each year, you could invest in a new 10-year bond, so you have bonds maturing every year. If interest rates go up, you will have the opportunity to buy a new bond that year. If interest rates go down, then at least you would have been able to take advantage of the higher rates with the bonds you bought last year.
How Do You Buy Bonds?
If you want to buy bonds issued by the U.S. Treasury, you can buy them directly from the government, using the TreasuryDirect.com website. Once you create an account, you can also buy Treasury bills, notes and savings bonds.
For most other bonds, the only way for an investor to buy them directly is to go through a bond broker, either through your bank or a securities company. Like stockbrokers, bond brokers research the different bonds that are available and will usually give you insight into the market and will help you decide which bonds are right for you to buy
A third way to buy bonds is through a bond fund. These are a type of mutual fund, where the fund managers buy a wide range of bonds instead of stocks. Many mutual funds, like balanced funds, also have a percentage of bonds in them in addition to stocks.
Are Bonds Safer Than Stocks?
Bonds are often described as being safer than stocks, but both have their strengths and weaknesses. If you buy bonds issued by the U.S. Treasury, for example, it's far less likely that you would lose your investment, compared to buying stocks in a new startup company. But bonds come with risks that you should fully understand before investing.
Interest rate risk: If interest rates rise, the value of a bond that was issued before the increase will fall, making it much harder to sell without losing money. On the other hand, if interest rates fall, the value of a bond can rise and may be easier to sell.
Inflation risk: Since bonds are long-term investments and the interest rates are fixed when you purchase them, there is always the risk that an increase in inflation could eat away at your investment. For example, if you bought a bond with a 3- percent interest rate and inflation increased to percent, then your investment would be losing money because the value of each dollar earned would be reduced by 2 percent. The longer you hold a bond, the more prone you are to inflation risk.
Call risk: Issuers of corporate and municipal bonds have the right to call back a bond before it has matured. When this happens, the issuer will pay you the par value of the bond, which may be below the bond’s market price.
Credit risk: If a bond issuer has financial problems, it may not be able to pay you the bond’s interest on time, or may not be able to pay the interest at all. If a company goes bankrupt, bondholders will be paid before stockholders, however, this does not guarantee that you will get anything back.
Liquidity risk: It's more difficult to sell bonds than it is to sell stocks. As such, they should usually be considered long-term investments.
Are Tax-Exempt Bonds Best?
While Treasury bonds and municipal bonds can offer significant tax advantages to investors, this doesn’t always mean they are the best investments. Before buying bonds, it’s a good idea to compare its yield with other investments by looking at their taxable equivalent rates. To do this, divide the tax-free rate you get on the bond by 1 minus your federal tax bracket. As an example, if your tax bracket is 30 percent and the bond gives you a tax-free interest rate of 5 percent, then the bond will give you a taxable equivalent rate of 7.1 percent.
Interest rate / (1 - tax bracket) = taxable equivalent
0.05 / (1-0.30) = 0.71
What Are Junk Bonds?
Like companies and consumers, bonds have credit ratings. A bond with a high credit rating is called an investment-grade bond, meaning the issuer is unlikely to default on it. A bond with a low credit rating is called a low-grade bond. These are usually issued by new companies and companies that are not as likely to be able to make good on their bonds. Those with very low credit ratings are called junk bonds. These are highly speculative because of the likelihood that the company may default on the bonds.
Bonds are rated with a system that begins with AAA, indicating that the bond is unlikely to default. The lowest rating is a D, which means there is a good chance the bond will default. Any bond with a rating of BB or lower can be called a junk bond.
Junk bonds often offer very high interest rates compared to other bonds, to make them more attractive to investors. Consequently, you could make a lot of money buying junk bonds, or you could lose a lot of money.