Bond Market Basics
A bonds is essentially a loan from the bond buyer (an individual or institutional investor) to the bond issuer (a corporation, municipality, or other government entity). Bonds are often referred to as "income securities" because, in return for the use of your money, the bond's issuer agrees to pay a certain rate of interest at regular intervals for a set period until the bond matures or the principal is otherwise repaid.
Bonds can be for varying lengths of time (maturities) and of varying quality. Short-term bonds are defined as those that mature in three years or less. Intermediate bonds mature in three to 10 years, and long-term bonds have maturities of 10 years or more. The quality of a bond relates to its risk of default, or non-repayment by its issuer. Bonds issued by the U.S. government are of higher quality than those issued by many state and municipal governments, because U.S. government securities are backed by you, the taxpayer, and thus are far less likely to default. Company-issued bonds can vary even more dramatically in quality. As with any investment, the higher the risk associated with an investment, the higher the potential return you generally can expect from it. Of course, the taxability of a bond's interest also will have an impact on the return.
What Are the Risks of Investing in Bonds?
Just like other investments, bonds expose you to certain types of risks. Depending on the quality of the bond, you may face the risk that the issuer could experience economic problems and be unable to make its interest payments. You can minimize this risk by investing in higher-quality bonds, but they will have a lower return than high-yield debt securities, otherwise known as "junk bonds."
Bond investments are also sensitive to movements in market interest rates. Typically, if interest rates rise, the value of your bonds will likely decline. Or, if interest rates decline, your bonds may increase in value but provide less income as they mature and are replaced with new ones. If you have invested in the bonds because you need that income for living expenses, this can pose a problem. You can minimize this risk by diversifying your bond portfolio among investments with a variety of different maturities, and by keeping some of your portfolio invested in stocks, which react to interest rate changes differently than bonds do.
The Relationship Between Bonds and Interest Rates
People often get confused by the inverse relationship between interest rates and bond prices. Here's why bond prices RISE when interest rates fall, and vice versa.
Let's say you want your bond to earn $50 in interest by year's end. If interest rates are 5%, you need to have a bond with a face value of $1,000 to earn $50 in interest. If interest rates fell to 4%, however, you would have to increase that face amount to $1,250 to earn the same $50. On the other hand, if interest rates rose to 6%, you would only have to buy a bond worth $832,50 to earn $50.
Here's another example. Ike and Holly each purchased a newly issued $20,000, 10-year U.S. government bond with a 5.5%* coupon rate (the bond's interest rate). The bonds were issued "at par" and thus they each paid $20,000. In exchange for "loaning" the government $20,000, Ike and Holly will each receive $1,100 a year for 10 years. At the end of the 10 years, Ike and Holly will get their $20,000 back.
Five years after purchasing his bond, Ike needs to sell it. The interest rates have risen since Ike purchased the bond, and newly issued 10-year government bonds are paying 7%. To find a buyer for his 5.5% bond, Ike is forced to sell it for less than the $20,000 face value.
Two years later, Holly also decides to sell her bond. Interest rates have dropped since Ike sold his bond, and new 10-year bonds are paying only 5% interest. Because of this, Holly is able to sell her bond for more than $20,000.
Taxable or Tax Exempt?
Some bonds offer special tax treatment on the interest they pay. There is no state or local income tax on the interest from U.S. Treasury bonds, and no federal income tax on the interest from most municipal bonds, and often no state or local income tax either.
Which is better for you, taxable income or income that is tax-exempt? The answer depends on your income tax bracket - and the difference between what can be earned from taxable versus tax-exempt securities - not only now but also throughout the period until your bonds mature. An investment advisor can show you how much taxable income you would need at each income tax bracket to match the return from a tax-exempt security.
The bond market is far more complex than the stock market in many ways. There are significantly more bonds on the market, more types of bonds than stocks, and pricing is not as transparent. Many people own bonds through mutual funds. Contact us to learn more about how bonds can help you pursue all your financial goals.
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, this information should be coordinated with individual professional advice. Source: Financial Visions, Inc.
