Bonds: Financing the future

A bond is a loan that pays interest over a fixed term, or period of time. When the bond matures at the end of the term, the principal, or investment amount, is repaid to the lender, or owner of the bond.

Typically, the rate at which interest is paid and the amount of each payment is fixed at the time the bond is offered for sale. That’s why bonds are known as fixed-income securities. It’s also one reason a bond seems less risky than an investment whose return might change dramatically in the short term.

A bond’s interest rate is competitive, which means that the rate it pays is generally about the same as the rate on comparable bonds being issued at the same time. The rate being paid is also determined in part by the cost of borrowing in the economy at large. So when interest rates drop, for example, rates offered on newly issued bonds also tend to be lower.

Types of bonds

You can buy bonds issued by US companies, by the US Treasury, by cities and states, and by various federal, state, and local government agencies. Many overseas companies and governments also sell bonds to US investors. When those bonds are sold in dollars rather than the currency of the issuing country, they’re sometimes known as yankee bonds. There is an advantage for individual investors: You don’t have to worry about currency fluctuations in figuring the bond’s worth.

Issuers prefer bonds

When companies need to raise money to invest in growth and development, they can issue stock or sell bonds. They often prefer bonds, in part because issuing more stock tends to dilute, or lessen, the value of shares investors already own. Bonds may also provide some income-tax advantages for the issuer.

Unlike companies, governments aren’t profit-making enterprises and can’t issue stock. Bonds are the primary way they raise money to fund capital improvements like roads or airports. Money from bond issues also keeps everyday operations running when other revenues (such as taxes, tolls, and other fees) aren’t available to cover current costs.

Issuing a bond

When a company or government wants to raise cash, it tests the waters by floating a bond. That is, it offers the public an opportunity to invest for a fixed period of time at a specific rate of interest. If investors think the rate justifies the risk and buy the bond, the issue floats. If there isn’t enough investor interest, the issue may be withdrawn. The exception is US Treasury issues, which are sold at auction.

The life of a bond

The life, or term, of any bond is fixed at the time of issue. It can range from short term (usually a year or less), to intermediate term (two to ten years), to long term (ten years or more).

The relationship between the interest rates paid on short-term and long-term bonds is called the yield curve. Generally speaking, the longer the term, the higher the interest rate that’s offered to make up for the additional risk of tying up your money for so long a time. When that’s the case, the yield curve is described as positive.

Making money with bonds

Conservative investors use bonds to provide a steady income. They buy a bond when it’s issued and hold it, expecting to receive regular, fixed-interest payments until the bond matures. Then they get the principal back to reinvest.

More aggressive investors trade bonds, or buy and sell as they might with stocks, hoping to make money by selling a bond for more than they paid for it. Bonds that are issued when interest rates are high become increasingly valuable when interest rates fall. That’s because investors are willing to pay more than face value for a bond with a 6% interest rate if the current rate is 4%.

In this way, an increase in the price of a bond, or its capital appreciation, often produces more profits for bond sellers than holding the bonds to maturity.

But there are also risks in bond trading. If interest rates go up, you may have a capital loss if you sell an older bond that is paying a lower rate of interest. In this instance, potential buyers will typically pay less for the bond than you paid to buy it because they’ll be earning less than the current rate.

The other risk bondholders face is rising inflation. Since the dollar amount you earn on a bond investment doesn’t change, the value of that money can be eroded by inflation. For example, if you held 30-year bonds paying $5,000 annual interest, the income would buy less at the end of the term than at the beginning.

How bonds are sold

For corporations, issuing a bond is a lot like making an initial public offering. An investment firm helps set the terms and often underwrites the sale by buying up the issue. In cooperation with other financial companies, the investment firm then offers the bonds for sale to the public.

When bonds are issued, they are sold at par, or face value, usually in units of $1,000, though you can rarely buy just one. The exception is US Treasury issues, where par value is $100 and you can buy just one if you prefer – or up to $5 million dollars’ worth in a single purchase. The issuer absorbs whatever sales charges there are. After issue, bonds trade in the secondary market, which means they are bought and sold through brokers, similar to the way stocks are traded. The issuing company gets no money from these secondary trades.

US Treasury issues are available directly to investors through auction, using a program known as Treasury Direct (www.treasurydirect.gov). Most agency bonds and municipal bonds are sold through brokers, who often buy large denomination bonds ($25,000 or more) and sell pieces of them to individual investors.

 

 

Copyright© 2017 Lightbulb Press

Additional Resources