This article addresses two basic questions to ask if you’re contemplating investment in bonds: Why? and How? At the end you’ll find a Glossary that defines possibly unfamiliar terms used in the discussion. For starters, you need to know that a bond is essentially a loan by the investor to a company, government entity, or basket of financial instruments and contains the following features:
Coupon: A contractually specified amount of annual interest, payable in two semiannual installments.
Maturity: The date on which the borrower must repay the loan in full. The XYZ Company 6% due 3/31/2036 is a bond paying 3% interest every six months that is required to repay its full par value on March 31, 2036.
Par Value: This is generally $1,000, but bonds are quoted as though the par amount, or face value, is 100. So a quote of 95.5 signifies a price of $955. No matter what price you pay when you buy the bond, your promised payment at maturity is $1,000.
Why Consider Investing in Bonds?
Most bond investors are motivated primarily by a desire to earn current income. For that purpose, bonds offer certain advantages over most other types of investments. To quantify those advantages, we utilize yield, which is in its simplest form is defined as follows:
Yield = Annual Income ÷ Price.
At the end of 2022, the yield on stocks, as represented by the Standard & Poor’s 500 Index, was 1.76%. That translates into annual income of $1,760 on a $100,000 investment, before taking into account any applicable taxes, fees or commissions. The comparable figure for the ICE BofA US Corporate Index of investment grade bonds was $4,280. For that provider’s index of speculative grade bonds, the amount was $6,750.
Advantages of Bonds over Stocks
Not only does the typical stock yield less than the going rate on bonds, but it’s based on dividend payments that are at the discretion of the board of directors. In tight times, the board may vote to reduce the dividend or eliminate it altogether, with no penalty other than perhaps a further hit to the stock price. (To be fair, the board can also vote to increase the dividend if things are going well.)
The situation is much different for a company that fails to make a scheduled interest payment on its bonds. That means the bonds are in default, with repercussions that may ultimately include shareholders losing their total investment as well as control of the company. To avoid such consequences, the board will usually go to great lengths to ensure that the company makes every debt payment in full and on time. In short, bond yields are both higher and more reliable than stock yields.
Bond Price Dynamics
Based on those comparisons, you might ask, “Why doesn’t everybody switch all of their holdings from stocks to bonds?” The answer is that bonds don’t offer the same appreciation potential as stocks. If a company is in a growing sector of the economy and it’s well managed, its earnings-per-share can be expected to grow over time. Even if the price-earnings multiple assigned by the market to those earnings doesn’t increase, its stock price will rise, providing a gain for stockholders on top of the dividend yield.
On the other hand, if you buy a bond at par, then at maturity you get the same amount back. You achieve no gain. That’s the tradeoff versus stocks—higher and safer current yield, but less potential for price appreciation.
Note that we say “less” not “zero” potential for a gain. A bond’s price isn’t completely static. As you can work out from the yield definition provided above, when a bond’s yield goes down, its price goes up. (Annual income doesn’t change.) If the general level of interest rates drops, then since your bond’s interest rate is constant, it becomes more valuable to investors and its price goes up. Applying the formula above, your bond’s yield goes down because its price rises.
Two caveats here: First, the price gain on your bond is capped on the upside. The scheduled payment of face amount at maturity acts like gravity, ultimately pulling your bond back to that level. In contrast, the shareholder’s upside is theoretically unlimited. The second caveat is that interest rates can rise, just as they can fall. That means that over time bonds, like stocks, experience declines as well as gains. When a bond’s price declines, though, the par-payoff-at-maturity feature acts as a levitational, rather than a gravitational force. For a stock, on the other hand, there’s no comparable obligation on the company’s part to redeem your security at a specified price on a specified date in the future.
Bonds versus Other Income-Focused Investments
Naturally, bonds shouldn’t be compared only with common stocks, most of which are not managed by their issuers’ boards with a primary objective of generating current income. You should also evaluate bonds in comparison with other income-focused investments. Choosing between them and bonds involve certain risk-reward trade offs. Here are some leading examples:
Bonds vs. Money Market Funds (MMFs):
These are high-quality, very short-term investments. The financial institutions that sponsor them try and usually succeed in keeping the price of fund shares at $1.00. Consequently, the risk is small that you’ll lose principal if you need to sell shares to raise cash. But MMFs are best suited to be part of your cash reserve, rather than a segment of your portfolio that you depend on for delivering the highest return consistent with your tolerance for risk. The bond market generally offers higher returns because at most times market yields are higher in long maturities than in short maturities. In addition, a bond’s price fluctuates with interest rates, rather than being maintained at par by some sponsoring institution. The market requires additional yield for that added degree of risk to principal.
Bonds vs. Bank Certificates of Deposit (CDs):
These are largely very short-term investments, so like money market funds they ordinarily yield less than longer-maturity bonds. A CD that is backed up by the Federal Deposit Insurance Corporation has an advantage over a corporate bond, though, in terms of the safety of its principal.
Bonds vs. Preferred Stocks:
Yields on these securities are often competitive with corporate bond yields. They are less safe than a bond, however, in terms of expected recovery of principal in the event of a default by the issuer. Many preferreds are “perpetuals,” without the stated maturity of a corporate bond.
Comparing Different Types of Bonds and Bond-Like Investments
Interest Rate Risks
Among obligations of the various types of bonds, such as U.S. Treasuries, federally sponsored government agency issues, corporate bonds, municipals (issued by state and local governments), asset-backed securities, and mortgage-backed securities, the general rule is that the greater the risk, the higher the yield. One risk already discussed consists of changes in a bond’s price related to fluctuations in the general level of interest rates. Within an issuer class, interest rate changes generally produce bigger price swings on long-maturity bonds than on short-maturity bonds. (A bond’s price sensitivity to interest rate changes can also be affected if the issuer has an option to redeem the bond prior to maturity.)
A very important differentiating factor among corporate bonds is their risk of default, i.e., the risk that the issuer will become financially unable or unwilling to make either scheduled interest payments or the required repayment of principal at maturity. Default risk encompasses both the probability of such a failure and the percentage of par that a bondholder can expect to recover in the event of default. Default risk is gauged by credit ratings assigned to bonds by such organizations as Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. Credit opinions are also published by brokerage houses and independent research firms.
Secondary Market Liquidity
One other risk is termed “secondary market liquidity.” The market requires a higher yield, all else being equal, on a bond that trades infrequently than on one for which several bond dealers almost always stand ready to buy or sell the issue. Secondary market liquidity is, to an important extent, a function of the bond’s issue size, i.e., the total dollar amount outstanding.
Tax Treatment of Bonds
Tax treatment of bonds varies according to type of issuer. For example, corporate bonds are subject to federal, state, and local taxes. State and local governments, as well as special authorities created by them, issue tax-exempt bonds, which are not subject to federal income tax and may also be exempt from state and local taxes. (Some of these entities also issue taxable bonds.) U.S. Treasury bonds may be exempt from state and local taxes. This paragraph should not be construed as tax advice. Consult your tax advisor before investing in bonds.
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GLOSSARY OF BOND TERMS
Asset-Backed Securities: Investment vehicles similar to mortgage-backed securities (SEE) but based on assets such as auto loans, credit card receivables, home equity loans, or student loans.
Balanced Portfolio: An investment portfolio that includes both stocks and bonds. One classic formula is to hold a mixture of 60% stocks and 40% bonds. Another approach is to decrease the stock portion as the investor nears retirement and becomes more focused on preserving accumulated wealth than on incurring the risk of attempting to increase it further.
Corporate: A taxable bond issued by a business organization.
Correlation: A measure of how two securities or classes of securities move in relation to each other. Correlations are denominated in a range of 1.0, indicating that the two items move perfectly in the same direction, and -1.0, indicating that the two items move perfectly in opposite directions with each other. A correlation of 0.0 indicates that there’s no tendency for the items to move either together or in opposition.
Default: A failure by a bond issuer to make a scheduled interest or principal payment. A corporation that defaults on its debt may end up filing for bankruptcy.
High Yield Bonds: Corporate bonds rated speculative-grade (SEE) but not in default. These issues are commonly disparaged as “junk bonds” in the media.
Investment-Grade: Higher-quality credit ratings applied to bonds. This category consists of ratings of Baa3 or higher by Moody’s Investors Service and BBB- or higher by Standard & Poor’s and Fitch Ratings.
Maturity: The date on which a bond’s issuer must repay the full par value to the bondholder.
Mortgage-Backed Securities: Securities that are treated as part of the bond market although strictly speaking they only resemble bonds. A mortgage-backed security is created by funding the coupons with the cash flows from home loans or other real estate debt instruments acquired from their originating banks.
Municipal: A bond issued by a state, county, or city government, or a another entity that can lawfully utilize those governments’ ability to issue bonds that are exempt from federal income taxes.
Net Asset Value (NAV): For an open-end or closed-end mutual fund, a quantity calculated by the formula (Assets – Liabilities) ÷ Number of Shares Outstanding. Closed-end fund buyers often focus on funds that are priced at a discount to NAV, but caution is required because a steep discount may reflect poor historical performance.
Par Value: The amount that the issuer must repay to the bondholder at maturity. This is generally $1,000 per bond, but quoted as Par = 100.
Secondary Market Liquidity: The extent to which an active market exists for bond investors who want to buy or sell an issue subsequent to its original offering.
Speculative-Grade: Lower-quality credit ratings applied to bonds. This category consists of ratings of Ba1 or lower by Moody’s Investors Service and BB+ or lower by Standard & Poor’s and Fitch Ratings.
Total Return: A measure of the performance of an investment over a specified period that takes into account both income earned and price gain or loss.
Yield: A measure of the income earned on an investment. The simple ratio Annual Income ÷ Price is known as “current yield.” In dealing with bonds you’ll come across alternative measures. “Yield-to-maturity” takes into account that if a bond is purchased above or below par, the investor’s return will reflect not only current yield but also a price decline or rise to par at maturity. “Yield-to-Call,” “Yield-to-Worst,” and “Effective Yield” deal with the complication that for some bonds, the issuer has the option to redeem the bond, beginning on a stated date prior at to the bond’s maturity, at a premium to par. That option affects the return on a bond as its price moves toward, and possibly above, the “call price,” which is the premium price above par at which the issuer can exercise its option to redeem the bond.