The following is a primer to help readers better understand their investments. Mission Financial Planning coordinates with clients' money managers as part of a comprehensive advice-only approach.
When you buy stocks, you own a piece of a company. When you buy a bond, you are lending the issuer money (the issuer could be a company, US Treasury, Federal agency, or municipality).
For the sake of this explanation we’ll assume our issuer is a company. Companies often issue bonds when they need financing; rather than going to a bank they borrow from investors. The company will issue a bond for a chosen period of time with a specific rate of interest. Investors will buy the bond, providing the funding for the loan to the company. Once the bond is issued and the company has its loan, people can buy and sell that debt on the open market much like they would buy and sell stocks. Because bonds are issued in limited blocks with specific time-frames and interest rates attached, they often don’t trade as frequently or easily as stocks do, but they do trade.
When you want to buy a piece of the debt issue, you will specify a principal amount. Bonds are usually interest-only loans; you loan the company money, they pay you interest for a specified time, and then pay back the principal on its due date (maturity).
If you buy $10,000 of a bond paying a 5% interest, you receive semi-annual interest checks worth $500 each year, and on maturity date you receive your principal ($10,000) back. If you don’t want to wait until the maturity date, you can sell your bond on the open market. Buyers will consider your bond’s quality, interest rate and the length of time until maturity to determine a fair price.
Let’s go back to that 5% bond and assume you want to sell it. If new bonds are being issued at 6%, people won’t pay as much for your 5% bond, all other things being equal. A quick calculation can determine how much less a buyer should pay to be compensated for receiving the smaller interest payment.
If instead, you wanted to sell your 5% bond when interest rates were at 4%, people would be paying handsomely for a bond that pays a higher coupon (rate of interest), so you might receive a premium (more than the principal amount) for deciding to sell.
Bonds are evaluated by rating companies (S&P, Moody’s) based on a company’s ability to pay off the debt. A bond’s rating helps you understand how much risk is associated with that bond, and rates the company’s ability to pay you interest and return your principal. A lower rated bond indicates a lower quality issue so you would expect them to pay a higher interest rate to compensate the investor for higher risk.
What happens if a company is unable to meet its obligation? The company may default on the bond and the investor could lose all of their principal. For this reason, it is important to check the strength of the issuer and to diversify your investments among different companies.
We like the predictable income that bonds can provide, and the promise of return-of-principal as long as the bond is held to maturity and the company is able to pay. For income-oriented investors, bonds are a prudent part of the investment mix.
Interest rates have been historically low, and bonds aren’t as attractive as they have been in other environments. As interest rates increase in the future, bonds will become a more exciting part of an income-oriented portfolio.
Mission Financial Planning is an independent advice-only financial planning and consulting firm. Our specialty is providing fee-for-service financial advice to dentists.