How Do Bonds Actually Work, Anyway?

Craig Donofrio — Break It Down

So far, 2018 has been, um, interesting for the stock market. And that may have you pondering less anxiety-provoking ways to invest your hard-earned cash, like bonds.

While bonds are a popular way to balance an investment portfolio’s overall risk, they don’t get the same attention from investors as their more exciting cousins, stocks. But that doesn’t mean bonds are boring.

What exactly is a bond?

Bonds are basically IOUs with interest. When you buy a bond, you lend money to an institution for a specific time period, during which you earn interest on the borrowed funds. Interest payments known as “coupon payments”—a throwback to the days when bondholders would show up at banks with paper coupons to collect—are based on a fixed rate and may be paid annually or twice a year. When the bond “matures” (meaning the predetermined payback period runs out), typically you get your original investment back on top of the interest. What the bond pays out at maturity is known as the “par value,” or “face value.” Bonds do not always trade at their par value; they may be priced higher or lower depending on interest rates. If a coupon is higher than the going interest rate, that bond may be priced above par, and vice versa. The issuer has control over the bond’s term length, which generally is no longer than 30 years.

Where do bonds come from?

While you can invest in any number of bonds, most retirement plans focus on “the big three”:

Government bonds: An example of a government bond is the T-Bond sold by the United States’ Treasury. Some government bonds are more stable than others—buying a T-bond from Uncle Sam’s reliable economy is a better bet than buying bonds from Zimbabwe, for example.

Corporate bonds: Corporations can issue bonds as a way of raising capital rather than giving up equity by offering stock. Corporate bonds work much like any other annual or semi-annual payout bond, except these tend to have lots of taxes attached to their coupon, which fall on the investor to pay. To offset this, the bonds carry higher interest rates.

Municipal bonds: Both state and local governments can issue bonds to help fund things like hospitals, schools, roads, or airports. The good thing about muni bonds is that, for the most part, their interest payments aren’t federally taxed. If you buy bonds from your state, they also are exempt from state tax. If you buy them from your local government, you don’t pay local taxes on them. On the downside, muni bonds are expensive—most municipal bonds require a $5,000 minimum investment. Comparatively, U.S. Treasury bonds typically require a minimum $1,000 buy-in through a broker, or you can even purchase $100 increments through Treasury Direct, according to The Motley Fool.

Not all bonds are the same

Bonds have different types and terms. The typical bond is one with a fixed interest rate, fixed interest payout dates, and one maturity date—aka a term bond. But there are other types.

  • Serial bonds: Instead of paying out all at once, serial bonds have multiple maturities. For example, a $50,000 10-year serial bond might pay out $25,000 annually over the last two years. While getting paid back faster might seem like a good thing, once the issuer starts to pay back some of the face value, you’ll have less principal remaining to earn interest.

  • Callable or redeemable bonds: Instead of waiting for maturity, the issuer can call back the bond, essentially buying back the original principal before it reaches maturity. Issuers like callable bonds because if interest rates drop, they can scoop up existing bonds that pay out higher interest, and then resell with lower interest rates. However, since the issuer has the advantage, callable bonds often pay higher rates than regular bonds to entice buyers. Municipal bonds are usually callable bonds.

  • Convertible bonds: These are corporate bonds that can be converted into company stock. Convertible bonds typically don’t convert at a 1:1 ratio, however. Instead, convertible bonds come with a specified conversion ratio. For example, a 20:1 conversion ratio means that every $1,000 in convertible bonds equals 20 shares of common stock. Because convertible bonds convert rather than mature, interest rates are typically low.

  • Zero coupon bonds: Zero coupon bonds aren’t paid out in interest over time like most bonds. Instead, buyers buy the bonds at a discount. Once the bond matures, buyers are paid the original face value for the bond, earning them a profit.

  • Junk bonds: Much like penny stocks, junk bonds are high risk. The issuer is thought to have a higher likelihood of defaulting, so the yield is higher to keep these bonds attractive.

  • Floating rate bond: Also known as a variable rate bond or adjustable rate bond, these bonds don’t offer a fixed interest rate. Instead, the interest rate you’ll earn is reset periodically throughout the life of the bond. The rate is usually tied to the federal funds rate or the London Interbank Offered Rate.

Risky business? It depends

While all investment vehicles carry some degree of risk, bonds are perceived to be generally low risk—but it really depends on the issuer.

“The likelihood that the issuer can repay the original investment when it’s due determines the quality of the bond,” explains Warren Ward, a certified financial planner and founder of Warren Ward Associates Financial Planning in Columbus, Indiana. In turn, the better quality the issuer, typically the lower the interest rate.

Potential investors can research bond ratings much like stock ratings. Bonds that are deemed “investment grade” by Standard & Poor and Fitch are rated at a minimum of “BBB,” while Moody’s investment grade bonds are rated at a minimum of “Baa.” Bonds with high ratings are low-risk bonds backed by issuers that are unlikely to default. But not all bonds are rated. Typically, bonds issued by smaller companies fall into the unrated category, making it more difficult to assess the risk.

And state governments, most of which are considered high-quality bond issuers, vary with their interest rates. The reason, says Ward, is that each state has its own credit rating. “Governmental bonds depend on the ability of the issuer to levy and collect taxes,” says Ward. “A faltering state like Illinois has a lower credit quality than Indiana right next door. But, because neither is as safe as the U.S. government, Indiana must pay higher rates than the U.S., and Illinois pays higher than Indiana.” Illinois’ current credit rating is “only one level above junk,” according to Bloomberg, while Indiana enjoys an AAA rating.

In corporate bonds, there will always be the risk that a company could end up being unable to pay back its debts, like Claire’s Stores, which recently filed Chapter 11. The company hopes to negotiate some sort of discount from its bondholders, according to Ward, but “will those bondholders accept perhaps 75 cents on the dollar against the chance of getting nothing in a liquidation?” Or consider guitar manufacturer Gibson, which owes $375 million bond maturity that’s due in August.

However, Ward says such cases are outliers. And even if a company does go belly-up, bondholders may still come out OK. “Generally, bonds are safer in that they receive preference ahead of stocks in such liquidations,” says Ward.

What about inflation?

Inflation favors the stock market more than bonds. The day you invest in a bond, the funds you put forward and the face value of the bond match dollar for dollar. But as time goes on and inflation kicks in, that same $1,000 or so you originally paid will be worth a little less. Meaning, when you do get paid back the value of the bond at maturity, you’ll actually be making less accounting for inflation. “Interest rates on extremely safe bonds always pay less than the rate of inflation,” says Ward.

There are some exceptions to the rule. Variable rate bonds don’t have a set rate, meaning the coupon rate fluctuates with the market. When interest rates go up, you could make more, reducing—or even beating—the impact of inflation. But rates could also go down, meaning you’d make less.

Buying bonds

Like stocks, bonds can be bought individually or through a mutual fund. While buying individually gives you total control, opting for a mutual fund can mean less hassle.

“If you own an individual bond, you receive the interest semi-annually and need to find a place to invest it. In a fund, this interest can be [automatically] reinvested in additional fund shares,” says Ward.

Either way, much like with the stock market, you don’t have to make a lifetime commitment. You can sell bonds before they mature, though you’ll have to take a haircut known as a “markdown.”

And while portfolios generally benefit from having a diverse blend of investment types, always do your research and compare potential gains between individual issuers and types of products. For example, in 1993 Disney sold $300 million worth of 100-year bonds. “They were snapped up immediately,” says Ward. Those bonds were issued at a 7.55 percent interest rate, meaning each $1,000 bond would yield a total of $7,555 in interest. If those bond buyers had bought Disney stock instead, they would have made much more money. During that time, Disney sold for around $12.33 per share. As of the time of this writing, Disney is selling for $102.11 per share.

Bonds may not make headlines like stocks do, but they play an important role in investment strategies all the same.