Friends with Bond-ifits: Bonds Are A Better Kind of FWB

bonds

I know, I know, FWB relationships are a bad idea. But what if that B stands for bonds and that friend is the US Government? Or Apple? Or the city of Los Angeles? In this kind of FWB situation, you give a little loan to one of these entities and it pays.

Now that we’ve revolutionized this acronym, let’s break it down.

Bonds are financial instruments, specifically, debt instruments.

While debt instruments probably bring to mind the four extra guitars your stoner college roommate had to hock to pay his second semester’s tuition, they are actually an essential part of the economy and part of a balanced investment portfolio.

A bond is a loan, and you’re the lender.

Sometimes a company, municipality, or government needs to raise funds. They might need funds to grow, develop, finance projects or operational costs, facilitate activities…or even make the payments on previous bonds! ?

An investor (you!) can then loan money to the company by purchasing those bonds.

But why would you want to loan a company or government your hard-earned cash? What’s the benefit of this FWB situation?

Issuers of bonds are borrowing funds for a defined period of time at a fixed interest rate*. Because you know the time frame and interest rate, you know how much money you are going to receive in interest in addition to getting the amount you lend back, and when. Hence the term fixed-income security.

Bonds are one of the three main asset classes. The other two are stocks and cash/cash equivalents.

Stock market is a pretty common term, but did you know that the bond market is even bigger than the equity market? Almost three times as large!

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So how does this work?

Companies issue bonds, and when they do, they specify what the money you are lending them is going to be used for.

It is important to note that all bonds (and all debt) are not created equal. Some debt is rated highly, and other debt is rated poorly**.

Highly-rated debt is called investment grade.

This indicates that the entity to which you are loaning your money has a very high chance of paying you back. Non-investment grade debt is sometimes called junk. Yep, junk. They put it right there in the name.

Examples of Investment Grade Debt:
Developed governments like the United States.
Major corporations like Disney.
Financial institutions like J.P. Morgan.

If a company isn’t rated as investment grade, they need to increase the incentive to buy their bonds, and they usually do this by offering a higher interest rate or coupon.

Ummm….what do coupons have to do with this?

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When talking about bonds, the coupon refers to the annual interest rate paid on a bond.

For most bonds, payments of this interest occur at the predetermined rate and schedule (remember the fixed part of fixed-income security).

Once upon a time when bonds were pretty pieces of paper rather than electronic transactions, coupons were bits of paper torn off of a bond and redeemed. Suddenly the term coupon is making a lot more sense, right?

Check out this bond issued by the US Government in 1918 to raise funds for the first World War! Coupons included! #FBF

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A coupon rate is the annual coupon payment received, relative to the bond’s face or par value and expressed as a percentage.  Don’t panic. Breathe. Par value is super easy to understand.

Par Value (aka Face Value) is the value the bond has on its maturity date. This is the value of your bond, it’s what you pay, and it’s printed right there on the bond! (See pretty vintage bond above!)

And while we would love it if maturity date had something to do with your last Tinder match calling you after your first date and suggesting dinner and a show for your second…it really only means the day you get back the money you put in — your principal. The day your loan is repaid. (Which is probably a better date than any you’re getting on Tinder anyway).

Bonds take various amounts of time to mature, from as little as a month to 100 years.

Here’s a simple example:

Good Ol’ Uncle Sam issues some bonds for $1000, with a coupon rate of 5%. This is paid semi-annually (twice a year), with a maturity of ten years. You buy it for $1000, loaning the government your money, and then collect $25, twice a year, for the next ten years. And then, if you keep your bond to maturity, you get back your 1K!

Those are the basics. If you need to go catch up on Westworld, we understand. However, you should probably stick around while we drop a bit more bond knowledge.

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The phrase “if you keep your bond to maturity” can be super important.

This is because a bond can be traded at any time, and its price changes all the time based on  the fundamentals of the company and supply and demand.

The yield of your bond is your coupon amount divided by the price of your bond.

If you’re really nerding out on this bond stuff, note that the yield of a bond will change as the price at which the bond is traded changes. This results in an inverse relationship between the yield of a bond and its price.  When bond prices go up, yields go down and vice versa. And when you buy a bond at par, the yield is equal to the interest rate! Simple!

But if the price of a bond rises or falls, the yield no longer matches the interest rate.

This is when you might hear the phrases “selling at a premium” or “selling at a discount.” This just describes whether the bond is trading above (premium) or below (discount) face value (par).

Let’s take a break from the parentheticals and wrap this up with a few final fun facts.

Just like with stocks, bonds are traded and you need a broker to do this buying and trading.

However, there’s a small exception with bonds! If you’re a US Citizen, you can buy Treasury bonds directly from the government, no middle-woman required. Check out Treasury Direct.

Investing in Treasury bonds is very low risk. However, if an entity is higher risk they have to offer a higher coupon rate to incentivize investors to take a chance and lend them money.  It’s a risk versus reward proposition.

Bonds, and the countries and companies that issue them, come in all shapes and sizes. They all need to raise money to fund themselves and issuing debt is one of the biggest ways they accomplish this.

Some bond issuers are rated below investment grade. These are called high-yield bonds and sometimes referred to as junk bonds. Generally speaking, these involve a higher level of risk, because they are perceived as more likely to default on their bonds (not pay you back). Because of this they often have to pay much higher interest rates to lure investors (think 10%).

On the other hand, some bonds are very low risk — those investment-grade bonds we keep mentioning. You are promised payments of a set amount, over a specific period of time, and then you get your original investment back. If you hold your bond to maturity that is…

So who’s gonna be your first Friend with Bond-ifits?

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*Bonds can also have variable interests rates. But we are focusing on the basics here. Let your curiosity lead you if you’d like to discover more about these variable interest rates after this Jargon Hack. **The “Big Three” of credit rating agencies are the S&P, Moody’s, and Fitch. Here’s a handy table of these ratings! In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.  Bonds sold or redeemed prior to maturity may be subject to loss.