Bond investment has been the backbone of many portfolios. From college students who just started investing to seasoned traders, everyone can benefit from these fixed-income products. Bonds are great investment tools to gain stable cash flow and diversification in your portfolio.

Investing in bonds can seem daunting at first but the principles are actually very simple and intuitive. If you are new to bond investing and eager to learn, this article will walk you through all the bond investing basics you need to know to become a savvy bond investor.  

What is a bond?

Bonds are debts. When you buy a bond, you are lending money to the company or government that issues it. In exchange for using your money, the issuer pays you regular interests (the bond coupons) before returning your original investment (the bond principal). The coupons on bonds are often fixed and paid regularly, giving investors stable investment income.

Why should I invest in bonds?

Bonds are one of the most popular investment options in the world. The popularity of bonds comes from their versatility. Bond investment plays a crucial role in almost any investment portfolio.

Stable income

Bonds are great tools to generate regular investment incomes. While companies can skip paying dividends to their equity investors, bond issuers are legally required to pay coupons and principals to bondholders. Unless the company went bankrupt, you know you will receive your coupon payments regularly.

This predictability helps investors meet their investment goals with certainty. Knowing exactly how much you will earn and when helps people plan for important events such as buying a house, paying for college, and retirement. Many retirees invest heavily in bonds and rely on their regular incomes to cover everyday expenses.

Low-volatility investment

In general, bonds are less volatile than equities; bond prices are less likely to experience extreme movements than equities. The chart below shows the month-to-month percentage change of S&P 500 equity index and Investment Grade Corporate Bond ETF. Compared to equities, bond prices are significantly less volatile. The monthly price change for investment-grade bonds is often between +/- 5%. On the other hand, equity fluctuation is much larger.

(*We use the iBoxx investment-grade ETF as a proxy for bond price index)

However, low volatility doesn’t translate into low risk. Volatility captures the price fluctuation of the investment; risk is the possibility of permanent losses. Although risk and volatility are related, they are not the same thing. Bond investment might not have large price movements but it doesn’t mean there is no risk of default. Depending on the credit quality of the issuer, high-yield bonds (non-investment grade) can be risky and investors can lose their money when a bond issuer defaults.

Diversification

Adding bond investments could be a great way to diversify your portfolio. Bonds and equities tend to be inversely correlated in recent years. This means when equities go up, bond prices are likely to go down. The inverse relationship is mainly driven by the effect of inflation in the current economy. Higher inflation is bad news for bond investors. The fixed interest payments from bonds will lose real purchasing power with higher inflation. On the flip side, inflation is a sign of a stronger economy and this prospect can boost stock prices.

For investors, the inverse relationship between bonds and equities is useful. When you have both in your portfolio, you reduce the volatility of your investment. When equities report losses, bonds might have a gain that can soften the blow and vice versa. Having both bonds and stocks in a portfolio increases diversification and reduces volatility.

Let’s talk about bonds

To be a bond investor, there are a few terminologies and principles you should master. While these principals can seem a little daunting at first, we assure you that with some practice you will talk about bonds like an expert!

Par value

Par value is also called the face value or the principal of the bond. It represents the amount of money bond issuers need to repay you at maturity. The par value of a bond is normally $100 or $1,000, also representing the minimum investment.

Coupon

A coupon is an interest payment investors receive from holding a bond. The coupon amount is the product of the coupon rate and par value. For example, if a bond has a 5% annual coupon rate and your par value is $1,000, you will receive a $50 coupon payment each year. Coupons can be paid quarterly, semiannually, or annually.

As an exception, zero-coupon bonds don’t pay any coupon but are sold at a discount to its par value. The difference between the purchase price and the par value represents the total interest investors will receive.

Maturity date

The maturity date is the date on which the bond issuer will have to repay your investment. When the bond matures, the bond issuer repays your investment and ends this debt relationship. The maturity date is the date for the last bond payment. There is a wide range of maturity for bonds, from a few months to even one hundred years, catering to different investor needs.

Bond price

Investors buy and sell their bonds in the market. The bond price is the current price people will pay for your bond and it can change daily. Interest rate, supply and demand, and the issuer’s credit rating all affect the bond price.

While a bond’s market price can change, its par value stays constant. The par value will still be $100, even as the bond price increases, because the issuer’s repayment obligation doesn’t change. The issuer still owes you the same amount of money.

Bond premium and discount

Bond price changes daily. When it goes above the par value, bond investors call the difference bond premium. When the bond price is lower than the par value, the difference is the bond discount.

When a bond bought on premium matures, investors will get back less than they paid for. On the other hand, when a discounted bond matures, bondholders will get back more in principal than the bond price.

Current yield

The current yield is the return (%) of a bond in the current year. The current yield is calculated by dividing the total annual coupon payment by the bond price.

Current\space Yield=\frac{(Annual\space Coupon\space Payment)}{(Bond\space Price)}

For example, a bond with a 4% coupon rate and a $100 par value pays $4 in coupon each year. If the market price goes up to $110, the current yield of the bond equals $4/$110, 3.64%.

Yield to maturity

The yield to maturity (YTM) differs from the current yield for it captures the total return of the bond if it is held to maturity, not just the current year. It takes into consideration coupon reinvestment and bond premium and discount. The YTM is mathematically complex but used most often by investors because it captures the total annualized return of their bond investment. The YTM is the most comprehensive measure of bond investment return.

Bond\ Price=\frac{Coupon_{1}}{(1+YTM)}+\frac{Coupon_{2}}{(1+YTM)^{2}}…+\frac{Coupon_{n}+Principal}{(1+YTM)^{n}}

You can find YTM on any bond online or from your brokers. If for any reason it is not available, you can also calculate it yourself using the formula below by solving. We, however, don’t recommend manually calculating this yield because of its complexity.  

The inverse relationship between bond price and the current yield

Perhaps the most crucial concept for any bond investor to grasp is the inverse relationship between bond price and current yield. Bond price goes up when the current yield goes down and vice versa.

The reasoning is best illustrated by looking at the formula for calculating the current yield. We know that the coupon on a bond is fixed till maturity. Additionally, we have the following formula to calculate the current yield.

Current\ Yield ↓ =\frac{Annual\ Coupon\ Rate}{Bond\ Price↑}

From the formula, we can see that given a fixed coupon, a higher price will lead to a lower current yield. A higher bond price means that the coupon payment is a smaller percentage of the price, thus a lower current yield. For example, if a bond with 5% coupon and $100 par value has a current market price of $120, the current yield would be 4.17%. Conversely, lower bond price means that the current yield on the bond is higher.

Mastering this relationship is fundamental. New investors often make the mistakes of thinking their investment has appreciated when the yield goes up. In reality, as we have learned, a rising current yield means your bond has decreased in value.

Types of bond investment

With a more in-depth knowledge of the bond market, the next step is to explore and understand the different bonds you can invest in. Bonds are categorized by the nature of the issuers. Typical bond issuers include governments, municipalities, and corporations.

Government bonds

Government bonds are secure investments with the payments backed by the full faith of the government.

In the US, the federal government is a major issuer of bond securities with more than $15 trillion of outstanding debt securities (source: US Treasury). The U.S. government bonds are considered risk-free investments because the bonds are covered by the credit of the U.S. government. Unfortunately, the yield on U.S. government bonds is also the lowest. Consequently, they are suitable for conservative investors with low risk tolerance.

Yet, not all government bonds are safe. For example, the 10yr government bond from Greece is extremely volatile. The country has a history of defaulting on bond payments. While risky, emerging country bonds can offer higher yields to investors. These bonds are more suitable for aggressive investors and strategies.

Municipal bonds

Municipal bonds are securities issued by state and local governments. For example, the state of California is a major issuer in the municipal bond market, using the money to build highways and water treatment facilities. The unique feature of municipal bonds is that they offer tax-free income. The income from most municipal bonds is exempt from federal taxes. Additionally, income from bonds issued by the U.S. territory such as Puerto Rico is further exempt from state and local taxes. Bonds issued by the states you live in are also exempt from state and local taxation with a few exceptions.

For investors with high federal and state tax rates, municipal bonds can offer attractive tax savings. You can learn more about municipal bonds here.

Corporate bonds

Corporate bonds are issued by companies around the world. Almost all companies issue debt securities. These bonds can be classified based on their credit rating or the industry the issuers are in. Compared to government bonds and municipal bonds, corporate bonds offer higher yields to compensate for the higher risks. For many investors, corporate bonds can help them boost investment returns.

Risk factors

Although generally considered a safer investment option, bond investment still has risks. Understanding the risk factors can help you minimize them and make informed investment decisions.

Interest rate risk

The interest rate has a large impact on bond prices. When a central bank raises the interest rate, bond prices fall. This is because in a high interest rate environment new bonds are issued with higher coupons than the existing bonds. Consequently, if bondholders want to sell their bonds, they have to reduce the price to attract buyers. Thus, the market value of the bond investment fluctuates according to the interest rate.

Investors can measure the potential impact of interest rate on their portfolio by calculating the duration of their investments. You can learn more about this concept in this article.

Credit risk

Bonds are debts. When you lend money to others, there is always a chance that they cannot pay you back. In the bond world, this inability to pay coupons or principal to bond investors is called a default.

Defaults can have different outcomes depending on the issuer’s financial strength. Sometime the issuer will get enough money to pay the bondholders eventually. Some issuers might offer a partial payment. Some cannot pay anything at all and the investors will lose their money.

Analyzing a company’s credit strength is very difficult for regular investors. Fortunately, there are several trusted rating agencies that help investors evaluate a company’s financial strength. The rating agencies review the financial strength of the company carefully and issue a rating. Investors can use this rating as a guide in selecting their investment.

The three most trusted rating agencies are S&P, Fitch, and Moody’s. You can find their rating scale below.

Rating Agency Scale

Moody's	S&P	Fitch	Category
Long-term Rating	Long-term Rating	Long-term Rating
Aaa	AAA	AAA	Prime
Aa1	AA+	AA+	High grade
Aa2	AA	AA
Aa3	AA-	AA-
A1	A+	A+	Upper medium grade
A2	A	A
A3	A-	A-
Baa1	BBB+	BBB+	Lower medium grade
Baa2	BBB	BBB
Baa3	BBB-	BBB-
Ba1	BB+	BB+	Non-investment grade
Ba2	BB	BB	speculative
Ba3	BB-	BB-
B1	B+	B+	Highly speculative
B2	B	B
B3	B-	B-
Caa1	CCC+	CCC+	Substantial risks
Caa2	CCC	CCC
Caa3	CCC-	CCC-
Ca	CC	CC	Extremely speculative
	C	C	Default imminent
C	RD	DDD	In default

Credit rating scale from Moody's, S&P, and Fitch.

Inflation risk

Inflation risk is the risk that the inflation growth can outpace your investment return, leaving you with less buying power. Bond investments are prone to inflation risks because of their fixed returns. For example, if your investment return is 3% but the inflation is 5%, your actual buying power decreases by 2% each year. So you are worse off at the end of your investment than before.

Some inflation-linked bonds have features that protect against inflation risks. For example, the US government issues Treasury Inflation Protected Securities (TIPS). These bonds can keep up with inflation and offer investors additional returns when inflation is high. However, inflation risk persists for these bonds, just in a different direction. If inflation is low, the TIPS holders will receive a lower yield on their investments than regular treasury bonds.

Conclusion

The bond market is the backbone of the financial system and a major source of income for investors. With a wide variety, bond investment helps investors achieve their goals with stable income. Understanding the principals of bond investment and the risk factors can help you make more informed decisions for your financial future.