Bonds are an integral part of most portfolios, yet many investors don’t really know what a bond is. On the basis that you should never invest in something that you don’t understand, it’s worth laying out a brief explanation of bonds; what types there are, how they work, and how they are priced.

The Basics: A bond is essentially a loan made by the investor to a borrower, usually a corporation or government entity. The borrower agrees to pay interest on the loan at a percentage of the amount borrowed. Each individual bond represents a set amount, say $100 or $1000 and the interest rate reflects prevailing rates at the time the bonds are issued. That rate is known as the “coupon” of the bond because at one time they were issued with removable strips, or coupons, that the bondholder redeemed at regular intervals for their interest payment. At the end of a pre-set time the bond “matures” and the borrowed amount is repaid in full.

How it Works: As an example, let’s assume that you bought a $100 ten-year bond with a ten percent coupon at the time it was issued. That ten percent is an annual return, but payments are usually made quarterly or every six months rather than annually, so you might, for example receive a payment of $2.50 every quarter for ten years. That payment remains the same in dollar terms throughout the bond’s life, hence the other term that traders and investors use for bonds – “fixed income.” At the end of the ten years you would be repaid your $100.

Types of Bonds: The first distinction that you need to know when it comes to bonds is between the types of issuer. There are three basic categories. Sovereign bonds are issued by the governments of nations, municipal bonds are issued by states and cities, and corporate bonds are issued by corporations. There are other categories within those, based on the length of time the bond was issued for and the credit status of the issuing entity. Corporate bonds, for example, are usually divided into “investment grade,” issued by big stable companies with excellent credit records, and “high yield” bonds issued by borrowers who present more of a risk.

Interest Rates: The interest rate on a bond is based mainly on three things, prevailing rates at the time of issue, the length of time to maturity, and the credit rating of the issuer. Those ratings are set by credit ratings agencies whose analysis study the balance sheets, history and prospects of an issuer and grade them according to how risky it is to lend to them. Interest is your reward for risk, so the higher the risk, the higher the interest rate.

Trading Bonds: Most investors do not buy bonds at issue, but through a secondary market where the bonds are traded. In that market, the price of the bond can be more or less than face value depending on prevailing interest rates. Obviously, nobody would buy a bond with four percent interest for face value if rates generally had risen since it was issued and similar bonds were now paying eight percent interest. The return in dollar terms is fixed, but by adjusting the price the bond can be made to return or “yield” the same as new issues.

Pricing: Prevailing intertest rates, as influenced by the Fed’s actions and market expectations are therefore one of the main drivers of the price of bonds. Changes in the issuer’s circumstances also affect pricing, however. If a company starts to struggle, not only will its share price drop but its bonds will too, resulting in a higher effective interest rate for those that buy the bond at the lower price. If the company that issued our example $100 bond with a ten percent coupon ran into trouble, investors would look for a return greater than 10 percent, but the ten-dollar per year payments remain fixed. In those circumstances, they may only be prepared to pay say $50 for that ten-dollar annual payment, resulting in a twenty percent interest rate.

Safety: Bonds are generally considered safer than stocks, but as you can see, their prices can also fluctuate. What makes them safer is that rates tend to move slowly so they are less volatile and in the event of a company going bankrupt, bondholders get paid first, reducing the risk of losing your capital. It is, however, not true that bonds cannot lose money.

As you can see, bonds are complicated things, and I have only covered the basics here. Knowing just those should make you a more informed investor though, and that can only be a good thing.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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