I have had a few new clients recently tell me they do not understand bonds and therefore have not invested in them. They are currently invested in money market funds or CDs, instead of bonds. This post should explain how bonds work and why investing in them is a good idea.
Basically, a bond is an IOU. Government entities or companies issue bonds. The purchaser gives the government entity or company some money in exchange for interest payments over a set number of years into the future and once that set time is up, the issuer returns the original principal.
In order for the issuer to attract someone to buy the bond (to give them money in exchange for an IOU), they must offer an interest rate that is competitive with other investments the investor could put their money in.
When the original purchaser buys the bond, they get the interest payments at the original offered percentage. Bonds can be bought and sold after the original purchase. The original interest payment amount transfers with a bond that is purchased after the original issue.
For example, a $1,000 bond offered originally at 5% would make payments each year of $50, regardless of if the original buyer later sold it.
Now let’s say interest rates have dropped (as might be the case in 2024). The offering company or government no longer needs to offer a bond at 5% to be competitive. Let’s say they can now offer 4% and still have enough buyers that they will sell all the bonds they offer.
The new bonds cost $1,000 and pay $40 per year. The people who bought the old bonds are happy because they will continue to receive their $50 per year. But what if they wanted to sell? Is their bond worth the $1,000 they paid for it? Or more? Or less?
Well, lots of buyers would prefer to pay $1,000 for a bond that pays 5% ($50/year) than to pay the same amount for a new bond that pays 4% ($40/year).
To make the percentage payout equal, the old bond should be worth more. A bond purchased for $1,250 that pays $50 has a payout percentage of 4%. The same percentage as a new $1,000 bond that pays $40. (In reality, bond pricing is more complicated than this.)
This shows the characteristic of bonds where the price goes in the opposite direction to the interest rate. The interest rate went down from 5% to 4%, but the price or value of bonds for sale on the open market went up. To keep this idea straight in my head, I always think through the thought process of a purchaser.
Bond values are expected to increase within the next 12 months when the Federal Reserve lowers interest rates. The people who already own bonds will continue to receive larger payments and the value of their bonds will go up. Therefore, it should be a good strategy to buy bonds now, before the interest rates drop.
Bond funds
Bond funds, either mutual funds or ETFs, are a combination of a lot of bonds. Usually thousands of bonds. They are issued by different entities, mature at different times, and have different interest rates on them. The fund manager buys and sells bonds to keep the fund’s characteristics at the desired values.
The desired values include statistics such as average time to maturity, type of issuer, taxable or tax-free, duration (which measures how sensitive the bond price is to interest rate changes), and others.
Types of Bonds
Bonds are offered at various interest rates, depending on the quality of the issuer. It makes sense that the Apple Corporation can attract investors without paying as high an interest rate as a less secure company such as Bed Bath and Beyond. There is always a risk that the issuer of the bond will not be around at the end of the bond’s term. The end of the term is called maturity. When a bond matures, the person who owns the bond receives their principal back, assuming the issuer has the money to pay them back.
Due to the quality of the issuer, there are different bond ratings. Investment grade is the highest level, and below a cutoff point, bonds are considered “high yield” or “junk” bonds. The “high yield” term makes sense because these companies must offer a higher yield to entice buyers since their bonds are at a higher risk of defaulting and not paying back the principal at maturity or making the payments along the way.
I don’t think retirees should be investing in high-yield bonds. Retirees should be investing in safe bonds from highly rated issuers, including the US government, so their money is available when needed to pay for living expenses.
There are ETFs and mutual funds that have sliced up the bond market in all sorts of ways. This allows an investor to purchase a fund with almost any desired characteristics.
