Bonds: What Are They and How Do They Work?

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The Basics

 This post provides essential background on bonds.  A bond is simply a loan from the buyer of the bond to its issuer. When an established company or a government needs to borrow, it doesn’t go to a commercial bank, as an individual or small business would, it hires an investment bank to issue bonds on its behalf. Each piece of this “paper,” as the financial community calls it, binds the business or government to repay the face value of the bond plus interest at a designated date.  At one time, investment banks actually issued paper certificates with dollar amounts printed on their face, which is where the expression “face amount” comes from.  Now, of course, almost everything is electronic.

Because bonds are promises, they are sometimes called “promissory notes.”  Because they are the issuer’s debt, they are also often called “debentures.”  But whatever the name, they bind the issuer to make the designated payments to the holder on time, hence the use of the word “bond,”as in “their word is their bond.”

In addition to issuing this debt, the financial community makes an active market by buying outstanding paper from existing owners and re-selling it to others. Because this “secondary market”gives those who first bought the bonds a way to get their money out before the bonds’ due date, maturity date, as it is frequently called, its existence encourages people to buy bond issues in the first place.

Prices in this secondary market fluctuate, depending on changes in demand and supply for bonds generally and also for specific bonds.  When investors have a growing appetite for bonds, the secondary markets fills with buyers.  Their demand pushes up prices, and, according to the nature of bonds, pushes yields down.   (Prices and yields always go in opposite directions.  At the end of this post, a box on “bond math” explains how this works.)  When a flood of new bond issues overwhelms buyers’ appetites or when many existing holders want to sell in the secondary market, the supply of bonds for sale exceeds the demand and prices tend to fall.  Yields accordingly rise.  (Again, see the box on “bond math.”)

Making Money in Bonds

 There are three ways to make money in bonds:

1. The primary way is through the regular payment of interest over the life of the bond.  Most bonds pay semi-annually, some quarterly.  Other bonds pay their accumulated interest in one lump at maturity.  (These are called “zeros,” because they pay nothing during the period from issuance to maturity.)
2. Money is made and lost in bonds when they appreciate or depreciate at maturity, depending on whether the buyer in the secondary market purchased at a discount or premium to their face amont. (See box on “bond math.”)
3. Because prices fluctuate over the life of the bond, you might also gain with a timely sale if you see the prevailing market price for the bond has risen above your purchase price.

The Roots of Price Fluctuations

Supply and demand fluctuate in the secondary market for a number of reasons, but four dominate:

Federal Reserve Policy

The Federal Reserve (Fed in financial jargon) is the government’s bank and the bankers’ bank, often referred to as the “central bank.”  Almost every nation has one to control flows of new money in their economies, mostly in order to smooth economic fluctuations.  When policy-makers want to raise economic activity, they increase the amount of money in circulation, and when they want to cool the economy, they decrease it.  These decisions affect bond prices.

When a central bank increases money flows it enlarges funds available for lending, heightening the demand for bonds, and thus lowering yields.  By reducing the cost of borrowing, the Fed encourages people and businesses to borrow and spend more, which speeds up the pace at which the economy’s wheels spin.  But when the Fed, needing to slow the economy, decreases the flow of money, the demand for bonds falls, their prices fall as well, and their yields rise.  Interest rates are so critical that the Fed announces its policy decisions in terms of short-term interest rates, specifically the rate that banks charge each other for overnight loans, the “federal funds rate.”  But while the Fed talks about a very short-term interest rate, its intent is to move the economy by affecting all rates and yields and thus bond prices.

Inflation

 Because bonds make all payments in fixed dollar amounts – both the repayment at maturity and the contracted rate of interest, called the coupon rate — they are especially vulnerable to the effects of inflation.  High rates of inflation quickly erode the real purchasing power of all these fixed dollar payments. In the early 1980s, when the United States suffered inflation rates higher than 10 percent, the real buying power of the fixed-dollar payments on bonds fell by half in less than seven years.  Needless to say, then, that investors shy away from bonds when they expect inflation to rise.  The resulting decline in demand depresses their prices and raises yields and continues to do so until investors believe that the yields bonds pay have risen high enough to compensate for the inflation-driven loss of purchasing power.  Of course, when investors expect less inflation, their interest in bonds intensifies, they buy, and all this happens in reverse.

Liquidity

Liquidity refers to how much money is readily available for the purchase and sale of securities – stocks and bonds.  In general, it affects prices in much the same way as does the Fed’s adjustments in the money supply.  Individual bonds have different liquidity considerations.

Bonds are said to be liquid when there is an abundance of potential buyers and sellers in the marketplace.  In this environment, traders can easily find buyers and sellers: in other words, they flow readily.  The most liquid issues in the world are US Treasury bonds.  Trillions of dollars of these bonds exist in the market and they are owned by millions of people and institutions.  There is a steady stream of new issues, while billions of dollars of bonds mature, that is come due for repayment every month.  Because the ease of trading makes investors feel more comfortable with US Treasuries, and similarly liquid bonds, they can pay a slightly lower yield than other, less liquid bonds.  Bonds that have unusual features or less active issuers or lower amounts circulating in markets are harder for traders to move and so tend to pay higher yields.  (This higher yield on illiquid bonds may appeal to investors who expect to hold them to maturity.)

Matters of Quality

 Supply, demand, and hence prices also vary according to what is called the “credit quality” of a bond.  Though the issuer is legally bound to fulfill its obligation, it cannot do so if it ceases to exist.  Companies sometimes go bankrupt, governments can be overthrown or go through something close to bankruptcy.  The greater the likelihood of such a mishap, the lower the bond’s price and accordingly the higher its yield, presumably to compensate investors for the potential of loss.  Some bonds, US Treasuries for instance, are all but certain to meet their obligations. They are considered to have the highest credit quality, and command relatively higher prices and offer lower yields than even the strongest corporation.

Three credit-rating agencies specialize in tracking the quality of bonds: Standard and Poor’s, www.standardandpoors.com; Moody’s,www.moodys.com; and Fitch, www.fitchratings.com.  They work for a fee, which issuers pay, hoping to get good ratings and so better prices for their bonds (and, accordingly, lower yields.)  Bond issuers also buy the ratings because a non-rated bond, as they are called, is suspect and thus harder to sell.

The ratings go from AAA, or some variation on this notation, for the most credit worthy issues down to CCC for the least.  The ratings are determined by the current financial health of the issuer, as well as future prospects, based on recent trends and likely potentials. Those rating the bonds also consider what are called bond covenants, which might put their owners first in line (or perhaps lower) for payment in the event of the issuer’s bankruptcy.  Because these agencies gave high ratings to undeserving bonds during the run-up to the severe 2008-09 financial crisis, governments, financial-professionals, investors, and others now rely less on their determinations.

How to Invest

 Whether an individual invests in bonds will depend heavily on what there other assets look like and a number of other considerations particular to them, their nearness to retirement and their comfort with risk just to name a couple of them. There are a great number of vehicles available for those who what to invest in bonds.  Buying them outright is sometimes difficult for the average investor because they are sold in large blocks.  But many mutual funds make bond investing straightforward and convenient for even small investors.  Future posts will go into these considerations in detail.

 

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Bond Math Made Simple

 Almost all bonds are issued with the interest indicated as a dollar payment at semi-annual intervals.  This amount is called the coupon, named after the tickets once attached to the old paper certificates that owners would clip off in order to claim their interest payment.  Say you bought $1,000 worth of a bond that paid $50 a year.  It would be referred to as a 5 percent bond because the indicated annual dollar payment would amount to 5 percent of the $1,000 purchase price.  This last figure is also often referred to as its “face amount” or “par”because that number once appeared on the face of the old paper certificates. It would pay you that $50 a year, $25 every six months, until the bond matures, when the issuer would return to you the $1,000 you paid for the bond.

Here is the relationship stated in a simple equation:

(semi-annual payment) × 2 = Annual payment                                                                                                                                        (annual payment in the secondary market ÷ face value) × 100 = annual percent interest.

In this example:

$25 every six months = $50 a year                                                                     ($50 ÷ $1000) × 100 = 5%

As supply and demand for bonds fluctuate in the secondary market, the changing price alters the calculation.  If a surge in demand drives up the price of a bond, an investor might have to pay $1,100 to buy the $1,000 face amount of this bond.  Financial jargon would describe the bond as selling at a 10 percent premium to par, because the $100 difference is 10 percent of the original $1,000 face, or par, amount.  Because the bond still pays $25 twice a year, that $50 a year is a smaller percent of the purchase price: to be exact, 4.5 percent.

(50 ÷ 1,100) × 100 = 4.5%

This rate is called the “current yield” — the fixed dollar amount paid each year as a percent of the purchase price.

Of course, the issuer will only repay $1,000 at maturity and not the $1,100 paid by the buyer in the secondary market.  To get a full picture of the bond’s return, the investor must also consider this $100 loss when the bond matures.  That means the overall percent return is really a little less than the 4.5 percent current yield.  Financial people use a complex formula to build this consideration into the percent return on the bond, what they call the “yield to maturity.”  There is no need here to go into the details of those calculations except to note that the more distant the maturity date, the less imposing the ultimate loss is and so the less significant is its impact on the calculation of yield to maturity.

This all works in reverse, if supply-demand fluctuations in the bond market reduce the price of the bond below par.  In this case, the fixed $50-a-year payment of our example would produce a current yield above the initial 5 percent.  If, for instance, a lack of demand drives down the price of our $1,000 face amount bond to, say, $900, a 10 percent “discount” in financial jargon, the “current yield” would come to 5.6 percent

 ($50 ÷ $900) x 100 = 5.6%

Because you bought the bond at a 10 percent discount, the $1,000 paid at maturity would also net you an extra $100 at that future date.  The “yield to maturity” would then exceed 5.6 percent.  How much would depend on the length of time from the purchase of the bond to its maturity date.

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