Understanding Bonds and How they Work

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Simpler Trading Team

Jul 08th 2022  .  12 min read

One of the first things to learn as you dive into investing is the superpower of compounding interest. Earning interest on interest is one of the top reasons why investing in the stock market and bonds makes sense. A bond is a debt security where a borrower will issue bonds to raise capital from investors.

When an investor purchases a bond, the investor gives money to the borrower for a specific time. Typically, a borrower could be a company, municipality, or government. However, bonds are considered a conservative way to trade, even for the risk threshold of an investor, but they are worth looking into, and in this article, we will go over the aspects of investing in bonds and what they can offer.

Compounding Superpower of Bonds

Time isn’t always on our side in trades. Time and compounding growth are best friends. Let’s say you invest $5,000 and add $100/month to your investment. On average, market returns are 8% annually. In five short years, your investment will grow to over $14,398! A diversified portfolio allows investors to divert a set percentage of money to equities (stocks) and a set amount to fixed income. Traders can then calculate how a bond investment will do by using a compounding interest calculator and a savings bond calculator.

Why Compound interest matters

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Regardless if you invest in bonds or not, bonds have a very integral part in the financial markets. If you are looking for an opportunity to get a high-level overview of the market, then consider signing up for Sam Shames’s report, This Week in the Market. Sam scouts and researches the market and tells you what his research entails. Sign up today and get his report every Sunday about his forecasts, scans on promising tickers and signals, and his personal list of sectors to focus on every week.

Tortoise Versus Hare Approach

In a typical economy, bonds don’t offer the same return the equity investor would expect. However, the ability to invest and reinvest to build up an account over time in a more stable manner gives traders and investors a valid reason to find bonds as an attractive means to balance out a portfolio in a highly volatile market. They make up for what bonds lack in high performance with the ability to compound and reinvest the previous growth on an account repeatedly.

There are several bonds available to investors. The bond definition is that investors purchase corporate or government debt units issued and securitized as tradeable assets. Classified as a fixed income instrument, bonds traditionally pay a fixed interest rate (or coupon) to debtholders. A bond may offer variable or floating interest rates.

So, what are bonds? A relatively simple approach to understanding a bond’s investment is that this is the reverse of a loan relationship. Rather than borrowing money, investors become lenders. The result is not only the return of the principal (or face value) at the end of the stated term but also interest earned.

Those interest rates are not typically as high as 8% but can still result in gains to grow an investment account. So, while we are investing in companies or government entities, it’s important to remember that, as “lenders,” bond investors are affected by the interest rate offered by the Federal Reserve.

Some key points to remember when considering bonds:

  • The interest payment is part of bondholders’ return for loaning their funds to the issuer. We call the interest rate that determines the payment the coupon rate.
  • Bond prices are inversely correlated with interest rates. When interest rates go up, bond prices fall and vice-versa.
  • Bonds have maturity dates, at which point the principal amount must be paid back in full or risk default by the issuer.
  • A bond investor is not required to hold a bond to its maturity date. The borrower may also repurchase bonds should interest rates decline or if the borrower’s credit has improved and they can reissue new bonds at a lower cost.
  • If the bond issuer has a poor credit rating, the risk of default is more significant. These bonds typically pay a higher interest rate than bonds with an extended maturity date.
  • Governments issue many bonds that can be purchased at banks or brokerage firms. Corporate bonds can be purchased from brokerage firms.

Although considered fixed income, bonds still have inherent risks, and investors should take time to understand their nuances. As we establish a solid bond investment, let’s consider the race between the tortoise and the hare. Investors who want to take a slower take may win the race.

Calculated Bond Market Approach

As the bond market has an inverse relationship to interest rates, a bond’s price varies inversely with interest rates. When the Federal Reserve increases interest rates, bond prices fall to have the effect of equalizing the interest rate on the bond with the prevailing rates and vice versa.

Market interest rates are a function of several factors, including the economy’s demand for the supply of money, the inflation rate, the stage that the business cycle is in, and the government’s monetary and fiscal policies.
How do investors calculate bond yield? Bond issuers agree to pay investors interest on bonds through the bond life and repay the face value of bonds upon maturity. The simplest way to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is called the coupon rate.

Coupon Rate

The current yield and the coupon rate are preliminary calculations for a bond’s yield because they do not account for the time value of money, maturity value, or payment frequency. More complex calculations are needed to see the complete picture of a bond’s yield.

Basically, if a bond has a face value of $1,000 and made interest or coupon payments of $100 per year, then its coupon rate is 10% ($100 / $1,000 = 10%).

Remember, a bond represents a promise by a borrower to pay a lender their principal and interest on a loan. Since governments, municipalities, and corporations issue bonds, the interest rate paid, the principal amount borrowed, and the loan maturities vary from one bond to the next to meet the bond issuer’s capital growth goals.

Since fixed-rate coupon bonds pay the same percentage of their face value over time, the bond’s market price fluctuates as the coupon becomes more or less attractive compared to the interest rates offered by the Federal Reserve.

Suppose a bond was issued with a coupon rate of 5% with a $1,000 par value. The bondholder will be paid $50 in interest income annually for the duration and until maturity. As long as nothing else changes in the interest rate environment, the bond’s price should remain at its par value – which is also called the face value- the value written on the front of the bond.

Should interest rates decline and similar bonds are now issued with a 3% coupon, the original bond has become a more valuable investment. Investors who want a higher coupon rate will have to pay more for the bond if the original owner is to sell it.

On the other hand, if interest rates rise and the coupon rate for bonds like this one increases to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and sell at a discount compared to the par value until its effective return is 6%.

The bond market tends to move inversely with interest rates because bonds will trade at a discount when interest rates are rising and at a premium when interest rates are falling.

Government Bonds

Government bonds can be purchased through financial institutions providing investment services to their clients. You also have the option to buy these securities directly from the government. U.S. Treasury bonds and bills (T-bonds and T-bills) can be purchased through TreasuryDirect.

Treasury Direct is an online platform allowing individuals to buy, sell and hold Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), Series I Bonds, and EE Savings Bonds electronically. No fees or commissions are charged –  but only U.S. citizens are allowed to purchase them.

Traders at Simpler Trading watch the 10-year U.S. Treasury bond yield closely, which is regarded as an indicator of broader investor confidence. Treasury bills, notes, and bonds carry the full backing of the U.S. government and are viewed as safe investments. The 10-year bond yield is used as a proxy for many other important financial matters, such as mortgage rates, and this also tends to signal investor confidence.

The 10-year Treasury is an economic indicator as its yield provides information about investor confidence since the U.S Treasury sells bonds via auction, and the yields are determined through bidding. When confidence is high, prices for the 10-year drop and yields rise because investors seek higher-returning investments elsewhere as they do not feel the need to play it safe with U.S. treasuries. When bond issuers seek investment capital, they are vying for those same investment dollars going elsewhere. 

Conversely, when investor confidence is low, bond prices rise, and yields fall, as there is more demand for “safe investments”. Bond issuers take advantage of lowered rates by offering the desired investment vehicles to investors at a competitive rate.

Time to maturity is an essential factor related to the resulting yield. Treasury bonds with a longer time to maturity, such as the 10-year, will have higher rates (or yields) because investors demand that they are paid more to compensate for the extended period their money is tied up. Typically, short-term debt produces lower results than long-term debt, which we refer to as a normal yield curve.

But, sometimes, the yield curve can be inverted – with shorter maturities paying higher yields. An inverted yield curve is considered to reflect expectations by investors of a decline in longer-term interest rates. This is typically associated with a recession.

During a rising interest rate environment, the original bond issuer may encounter difficulty when looking for a buyer willing to pay par value for their bond. After all, a buyer could purchase a newly issued bond with a higher coupon amount. This could result in the issuer offering to sell that bond at a discount from par value to attract a buyer. 

This inverse relationship exists between the interest rates in the markets and bond prices during a falling interest-rate environment, as well – and further shows that the relationship between the price of a bond and market interest rates represents supply and demand for a bond in a changing interest-rate environment.

When looking at the bond markets during periods of economic volatility and global uncertainty, traders can look into several types of bonds and exchange-traded funds based on bonds and treasuries. Investing in bonds requires a lot of due diligence. However, if you simply do not have time to research the market then consider Sam Shames’s, weekly report This Week in the Market. Sign up today and get his report every Sunday about his research and what he finds in the market.

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FAQs on Investing in Bonds

Q: What is the difference between par value and face value?

A: Par value and face value mean the same and are terms most often used with bonds, as they represent how much a bond will be worth at the time of the bond’s maturity.
Par – and face value – is the dollar amount that bond issuers promise to repay at a future date.
For instance, a county might issue $50,000, 15-year bonds to the public for a library. The par value of these bonds is $50,000. In other words, the county promises to pay the bondholders back $50,000 at maturity – or 15 years from the bond issuance.
Sometimes, bonds are not issued at their par value. Some bonds are issued at a discount (lower than par value) and some bonds are issued at a premium (higher than par value). The issue price does not affect the par value. The par value always remains the same and equals the amount of money the bond issuer must pay the bondholder when the bond matures.

Q: What are the most recent inverted yield curves that resulted in recessions?

A: Although it provided a false positive in the mid-1960s, the 10-year to 2-year Treasury spread has long been considered helpful as a recession indicator. In 1998, this spread briefly inverted after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped avoid a U.S. recession.
In 2006, the spread inverted for much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. The Great Recession began in December 2007. On Aug. 28, 2019, the 10-year/2-year spread briefly went negative. The U.S. economy suffered a two-month recession in February and March 2020 amid the outbreak of the COVID-19 pandemic.
An inverted yield curve has often preceded recessions in recent decades. However, it does not cause them. Instead, bond prices reflect investors’ expectations that longer-term yields will decline in anticipation of a recession. 

Q: Are bonds completely safe?

A: Just like any investment available in the market, bond investments can go south. If the bond issuer has a poor credit rating, the risk of default is more significant. These bonds typically pay a higher interest rate than bonds with an extended maturity date.
Bond defaults can happen when a company stops paying interest on a bond or, worse, does not repay the principal at maturity.  While treasury securities are considered risk-free because the credit of the US government backs them, corporate bonds default on a regular basis. When a company defaults, the government is under no obligation to and rarely rescues the company.

Q: Are bonds a good investment?

A: The answer is subjective to every investors risk threshold and goals, but bonds can offer a steady fixed rate of interest. So, if investors are looking for a fixed interest rate, bonds can help accomplish that goal.

Q: What are the different types of bonds?

A: There are many types of bonds that investors can invest in, and below you can find some of the most popular:
Corporate Bonds
U.S. Treasury Bonds
Agency Bonds
Municipal Bonds
U.S. Savings Bonds

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