What are Bonds?

 

 

A bond is a security issued by a company where in exchange for money today, the company will offer you a small payout over time.

 

A typical bond investment goes something like this:

(click image below to enlarge)

How a bond works

 

Consider going to the bank for a loan on a new car. The bank agrees to give you a lump sum payment and in exchange you pay the bank every month until the loan is paid off, and of course the bank tacks on a little interest too so they can make money. Bonds are very similar, only investors are acting as the bank. By buying a bond, you are funding the companyʼs debt, and they agree to pay you back over time, with interest.

 

Consider a hypothetical company that offers a $1,000 bond yielding 5% that matures in 5 years. This means the company is effectively taking out a $1,000 loan, paying 5% interest and will pay the bond back in 5 years.

 

If you were to buy this bond, you would give the company $1,000 today, this initial $1,000 is called the principal investment. In exchange the company would give you 5% of $1,000 every year, or $50 a year for 5 years. At the end of the 5 years, you would receive your principal investment of $1,000 back. In total you would have 5 payments of $50 and your principal of $1,000, giving you $1,250. A nice gain of $250!

 

Notice that corporate bonds work a little differently than the personal loans we are used to dealing with. Generally, corporations do not pay back any principal on the bond until the bond matures, investors only receive interest until the bond matures.

 

Bonds are considered “Fixed Income” securities because they offer scheduled predetermined payments (Sometimes called the Bond’s Coupon or Coupon Rate). In our example above, the investor is always going to receive $50 a year. However what can change is the yield of the bond and its price.

 

The initial investor in the example above paid $1,000 to get $50 a year. Here the bond is yielding 5%.

 

However that initial investor may want to sell that bond before its 5 year maturity arrives. The initial investor goes into the “secondary bond market” where other investors look to buy and sell bonds. Investors may be willing to pay more (or less) than $1,000 for that bond based on the economy. If interest rates are low and the economy is weak, like in 2012, investors may be willing to pay more for higher yielding bonds from high quality

corporations.

 

Lets say a new investor is willing to pay $1,100 for this bond. For this new investor, he will still only receive $50 a year and only $1,000 for the bond upon its maturity. Notice that this new investor does not receive a 5% yield on the $1,100 he paid for the bond, he receives the same $50, which is less than 5% of his $1,100. In fact, $50 is only 4.54% of $1,100. Even though the bond is paying out the same amount, it is yielding a

lower amount because the new investor paid more for the bond than the initial investor.

 

This is a very important beginning concept in investing.

As a bondʼs Price moves higher, its Yield moves lower.

As a bondʼs price falls, its yield moves higher.

 

For a closer look at the relationship between a bond’s price and a bond’s yield, see our article here.

 

We discuss bonds in much greater detail, including looking at a specific corporate bond and defining all the terms an investor needs to know before investing in bonds, in part 3 of our getting started series, available here.

 

 

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