Stephen Smart has 37 years of financial analysis experience and is here today to share his bond expertise with Hello, Life Skills! For beginner investors, it can seem daunting, but this article makes it easy to understand the basics and how you can start investing in bonds.
What are bonds?
A bond is essentially an IOU. When you buy a bond, the seller has entered into a contract with you to deliver you the “principal” at some specified future date, such as January 1, 2025. The principal is simply the face value of the bond, which for new bonds, is generally about 100 cents on the dollar, or “par value”.
For example, if you buy $10,000 of a bond maturing on January 1, 2025 at par (most new bonds are issued at or near par, or 100% of the principal), then the seller has contracted to give you back your $10,000 on January 1, 2025.
How do you make money with bonds?
You also get interest income on your bond. Known as “coupon income,” it usually involves getting paid a pre-specified amount of income, usually twice a year. In this case, if you bought the bond at a 5% interest rate, or “yield”, the seller is obliged to pay you ten installments of interest, each representing 2 ½% of the par amount. In this case you would receive $250 every January 1 and every July 1. Thus every year you will receive $250 x 2 = $500, which is 5% of your par amount each year. That’s why in total, you will receive a 5% annualized interest rate, getting $500 each year until the contract ends (the “maturity” of the bond).
There are many types of bonds, but investors usually cannot afford to buy individual bonds because the markets are not “liquid” for small amounts, even buying as much as $50,000 doesn’t give you much “liquidity” (liquidity being defined as the ability to sell something near where you bought it).
The only bonds that have liquidity for small amounts are U.S. Treasury bonds. These are backed by the full faith and credit of the United States. Therefore, they have the lowest interest rates and are currently not attractive to buy. For example, if you were to buy $10,000 of a U.S. Treasury bond today, a bond maturing in ten years, you would receive only a minuscule 0.7% interest rate. Hard to believe, but you would receive only about $70 dollars a year in interest, which is not only well below the rate of inflation, but the bond also includes “principal risk”. That means if interest rates rise while you own the bond, the value of your investment will fall, so if you were to sell it before maturity, you would incur a loss. So it’s currently not a good time to invest in U.S. Treasury bonds.
Why invest in bonds at all?
A good question to ask today, but there is an alternative, although it is riskier. You can invest in a collection of bonds which are bundled together to trade like a stock, with some liquidity on the New York Stock Exchange. These are called “exchange-traded bonds” or ETFs. They are the lowest cost and liquidity-effective way to invest in bonds as a small investor.
I cannot recommend any individual bond ETFs because this website is not a financial advisor or a broker. Bond funds based upon U.S. Treasuries, or very high-quality U.S. corporate bonds, pay very little in terms of expected return, since the interest rate on the portfolio you are in effect buying is currently at or near record lows. For example, the effective yield on AAA-rated bonds is a mere 1.7% as of 5/21/2020, and the effective yield for A-rated bonds isn’t much better (2.1%). That being said, many ETFs involve medium-yield (BBB-rated bonds’ effective yield is 3.2%) and/or high-yield (BB rated and below, approximately 7% effective yield) bonds of major American corporations.
Defaulting: how you can lose money
As of the time of writing this, we are experiencing a wave of corporate bankruptcies due to COVID-19. You may have seen the headlines that J. Crew, Neiman Marcus, and Hertz, to name only the largest companies, have recently filed for bankruptcy. When they do that, they stop paying (“default”) on their bonds that they have issued, leaving the high-yield bond investors with large losses.
One passive way to invest in bonds is to choose bond funds as an option for your 401(k) plan, if you have one. The caveat of current low yields applies here.
If you already have a broker, you can ask them which bond ETFs are available to buy and what they contain by rating category. Some may be at attractive prices now (meaning they have fallen in price) due to the rise in corporate defaults. But as of June 2020, it’s a really risky time to invest in bonds. This won’t always be the case though.
The whole dynamic of owning bonds is that bonds generally go down in price less than stocks in an economic downturn. In an upturn, bonds tend to go up less in price than stocks do. So far in this COVID-19-induced recession, this relationship has been true, so “diversification” into a combination of stocks and bonds has been beneficial for investors, compared to those investors who were entirely invested in stocks. That is the biggest reason to invest in bonds at any time in the business cycle, because you never know when stocks are about to plunge, and your risk tolerance might not be large enough to stomach being 100% in stocks.