20 Essential Features of Bonds You Need to Know
This article covers 20 essential features of bonds. You need to know them before investing.
Bonds are loans to a company or government. You lend them the money for a set amount of time and they agree to pay you back in full on a particular date and they pay you interest for your trouble.
Whereas stocks provide higher returns, bonds can provide your investment portfolio with income and stability.
Something that should be pretty simple can quite easily get submerged in a sea of financial jargon. To help you on your way the following list details the 20 essential features of bonds.
20 Essential Features of Bonds
Portfolio Protection
Bonds protect your portfolio in the bad times. In 2008 a portfolio split equally between global stocks and bonds dropped less than 20%, compared to a total stock portfolio which dropped over 40%. On the other hand a portfolio containing only bonds actually went up around 5%.
Of course at other times stocks outperformed bonds, but not by as much as you might think. Over the last 30 years a total global stock portfolio would have gone up annually at about 8.2%, a 50/50 split 7.5% and all bonds 5.8%.
Default/Credit Risk
When you lend organizations money, you need to think about the fact that the guys who borrow your money might not be able to pay you back. Usually, the higher the interest yield you can receive the greater the risk that you may not get your money back.
As a result, be aware of bonds paying higher interest. There’s likely to be a reason for this (You can read more about bond default risk here.)
Maturity Risk
The longer you hold bonds for, the more risky they become. The longer the maturity the more chance they have of being influenced by interests rates or inflation. When interest rates go up, bond values go down and the higher the inflation the lower the real return you get from your bonds.
Face/Par Value
You lend a set amount to an organization and they agree to pay you back in full on a set date. The Face/Par Value is the amount they will pay you on that date. If you sold the bond before that date to another buyer you may get a different amount, due to interest rate fluctuations.
As long as you can keep your bonds until the agreed date and providing the borrower doesn’t go bankrupt you will get your money back in full.
Coupon/Yield
This is the amount of interest you get. Say you invest in a £100 bond with a 5% coupon. This means the borrower will pay you £5 annually for lending them the money. This is usually split into at least a couple of semi-annual payments. So in that case you’d get £2.50 every 6 months.
The yield is influenced by interest rates, inflation and default risk. All things being equal, the bigger the yield the better. That said, higher yields tend to be a trade off against risk. The higher the yield usually means the more risk you take on.
Fixed Rate Yield
This means the yield remains the same for the life of the bond.
Variable Rate Yield
This is where the yield moves up and down in accordance with some kind of benchmark, such as a 10-year government bond.
Zero-Coupon Bonds
Some bonds don’t have a coupon/yield. They are sold at a discount instead. For example, you lend me £80 and I agree to pay you back £100 in 5 years time.
Maturity
This is the date at which you get your money back. Corporate bonds typically come with 1 to 5 year maturities, where as government bonds can be anywhere between a few months and 30 years.
Generally, bonds with maturities of less than 4 years are called short-term bonds. Bonds with maturities of 5-10 years are intermediate term bonds and anything over 10 years is long term.
Issuer
This is the organization that you lend your money to. The more trustworthy the issuer, the more likely you are to get your money back, but the lower the coupon.
Developed country government bonds, particularly those of the US government are often termed risk-free assets. With the power to print as much money as they want, it is unlikely the US government will run out of money and default on its bonds anytime soon.
Bond Rating
Some companies and governments have a lower default/credit risk than others. There are a handful of rating agencies that are charged with helping investors understand an organization’s credit/default risk. Different organizations have different rating systems.
Moody’s go from Aaa for the best bonds to Caa-C for the worst and Standard and Poor’s go from AAA to CCC-C. Further, there are another 5 ratings between the two. In general though, bonds are considered either investment grade or non-investment grade. As the name suggests investment grade are better than non-investment grade.
Junk / High Yield Bonds
Both junk and yield are alternative names for non-investment grade bonds. The clues are in the names. This type of bond generally pays more interest, but that’s because it is more likely for something to go wrong.
Whether a bond is considered investment grade or junk is determined by rating agencies. A Standard & Poor’s rating of BBB or above and a Moody’s rating of Baaa3 or above signifies investment grade (IG). Ratings below these are considered non-investment grade or Junk.
Ownership Rights
Unlike stocks, corporate bonds do not provide you with any ownership rights. As a result you wouldn’t benefit in the growth of a company in the same way you would by owning stocks.
However, bond holders are usually in a better position in the bad times, because you will still get paid as long as the company has the money to pay you.
Bond Trading
If you hold a bond to maturity you will get back the money you loaned the organization, and you will have been paid interest for your trouble so you will have made money.
That said, as soon as bonds are issued their prices can begin to fluctuate. Interest rates and the state of the issuer can influence bond prices. As a result there are traders out there that specialize in buying and selling bonds to take advantage of these price changes.
Inflation Linked/Protected bonds
As the name suggests, inflation linked bonds are linked to inflation, which means they increase in value with inflation. For example, let’s say you invest in a £100 inflation linked bond with a 5% coupon paying £5 per year. Let’s also say that inflation is 10%.
The inflation linked bond will increase in value by 10% inline with inflation so your bond will now be worth £110. Furthermore, your coupon rate will also increase because 5% of £110 is £5.50.
On the downside, inflation linked bonds usually have marginally lower interest rates or coupons than other bonds.
On the upside, unlike other bonds, there is no risk that they are going to lose purchasing power. They don’t correlate particularly well with stocks or other bonds either, so they can add further diversification to your portfolio.
Bond Choice
When you choose which bonds to invest in, you need to think about the maturity and the risk. Short term or inflation linked government bonds of developed nations are generally considered to have the lowest risk, but also tend of offer the lowest yields.
As investors move away from this type of bonds towards developing countries’ government bonds or corporate bonds, the yields of such bonds will increase, but at the same time so will the risk. The bonds of a company that has a good chance of default are likely to be very high for example.
Treasuries
Treasuries is the name used to describe US government bonds. The vast majority of investors have some treasuries in their investment portfolio. You’ll often hear the terms: Treasury bills, Treasury notes, Treasury bonds and TIPs.
Bills have maturities of one year or less, notes have maturities between 2 and 10 years, bonds have maturities between 10 and 30 years and TIPS stands for Treasury Inflation-Protected Securities. As the name suggests, TIPS have a return that fluctuates with inflation.
Gilts
Gilts are British government bonds. The unusual name comes from the fact that the original certificates you received when you bought gilts used to have gilded edges.
Liquidity
Liquidity refers to the ease of buying and selling. Some bonds will be difficult to buy and sell and some bonds will be easy to buy and sell. US government bonds are extremely liquid for example.
Domestic vs Foreign
Domestic bonds are the bonds of the country where you live, where as foreign bonds are the bonds of other countries. People have different opinions as to whether you should invest in one or the other or both. (You can read more about this here.)
The Bottom Line
These twenty features of bonds is not exhaustive but it does cover the most important features of bonds.
Bonds aren’t the most exciting investment product available, but they serve a purpose. Most investors should have some bonds in their investment portfolio.
You can read more about bonds here.
