How do bonds work and are they worth it?

You probably know how to find and buy stocks, but how do bonds work?

Unfortunately, while online stock brokers have made stock investing child's play over the last 10 years, bond investing has been slow to catch up. In fact, on many online broker sites, online bond platforms don't even exist. That's made the world of individual bond investing pretty murky.

You know that a certain percentage of your portfolio should be allocated to bonds (say 40% if you're in your 40s), but you've probably relied on bond mutual funds to do that. And that's not a bad thing: Bond mutual funds let you own bonds from hundreds of companies with only a small investment. They also have professional managers who can do research into bond investments for you. But bond funds also have one, significant disadvantage to owning individual bonds.

When you buy a bond, you know:

  • exactly what your interest payments will be,
  • when you'll get them, and
  • when you'll get your initial investment back as long as the company doesn't default.

The prices of bond funds, on the other hand, move up and down just like any other mutual fund. If you need your money on a specific date, you'll have no idea what your mutual fund will be worth. That can make investing in individual bonds preferable for people who need a specific amount of money at a specific time.

For example, you might need to make a $40,000 tuition payment for your college-bound 16-year old in exactly two years. Invest $40,000 in two-year individual bonds, and you'll have that money back when you need it (as long as the company doesn't go bankrupt). But invest it in a bond mutual fund, and who knows what it'll be worth when it's time to withdraw? Although bond funds typically don't go down by large percentages, 2008 taught us that that isn't always the case.

If you are saving for a time-sensitive goal (or need a stream of retirement income) and think you might be a candidate for investing in individual bonds, here's a primer on how they work.

How Bonds Work

The Treasury department issues Treasury bonds to finance the operation of the federal government. In the same way, companies, states, and cities issue bonds to finance their own operations. Treasury bonds are considered to have no risk of defaulting. So when a company needs to raise money, investors will demand an interest rate that's a bit higher than what Treasury bonds are offering in order to compensate the investors for the risk that the company goes bankrupt.

Let's say a company (I'll use GE just by way of example) needed to raise $100 million to build a new refrigerator factory and wanted to pay the money back in the year 2020. GE would look to the market to determine what interest rate it would need to offer to get investors to lend them the money. If investors demanded 6%, GE would issue $100 million in bonds with a “coupon rate” (the interest rate) of 6% that would be immediately bought by pre-agreed upon banks, funds, and sometimes, individuals. Most company bonds come in $1,000 denominations (the $1,000 is called “par value”). So for each $1,000 bond that the investor owned, he'd get $60 (6% of $1,000) per year, every year until 2020, at which time he'd get his $1,000 back.

In between the time when GE issues the bond and the time when the bond “matures” (i.e. comes due), investors can sell the bonds on the secondary market. But just like a stock price, the bond price will fluctuate.

Let's say GE issued that bond three years ago, and since then, the company's prospects of surviving until 2020, while still good, are decidedly gloomier. If an investor sells his bond today, the buyer will want an interest rate higher than the original 6% to compensate for the extra risk. GE will still pay the new investor $60 per year. So instead, the investor will want to buy the bond for less than par value.

If the new investor buys the bond for $900, while the coupon rate will still be 6%, the yield will be higher — both because he only has to invest $900 to get $60 a year and because he'll get back $1,000 when the bond matures.

The same thing can happen in reverse, and sometimes investors will buy bonds for above par value, reducing the yield.

Related >> Beginners guide to investing

The Trouble with Buying Bonds

Unfortunately, small investors have a lot more trouble buying individual bonds than they do buying individual stocks. For one, there are simply a lot more bonds than there are stocks. Think about it: A single company could have a dozen times when it wanted to borrow money (meaning it'd have 12 different bonds on the market versus one common stock).

But more important, the actual process of buying a bond isn't easy. Stock brokers most often act as intermediaries between buyers and sellers. Bond brokers, on the other hand, are often the actual investors who will buy or sell you the bond. So as an individual bond investor, unless you have multiple brokers, your investments will be limited to the bonds that your broker has in his inventory.

Bond commissions can also be confusing. Whereas you might pay a flat commission to buy and sell stocks, the commission on bonds is built into the bond's price. So, for example, if your broker originally bought the bond for $1,000 and it yielded 7%, he might sell it to you for $1,100, in which case it would only yield 6.4% for you ($70 divided by $1,100). The spread between his buying price and his selling price is effectively his commission. Big investors, who can sink millions of dollars into a bond at once, also tend to get better prices than small investors, who might only be able to buy $10,000 worth of a bond.

For the longest time, small investors couldn't see how much other investors were buying and selling bonds for, meaning that their broker could seriously rip them off. Fortunately, SIFMA has put together a website where you can look up the prices of recent bond transactions.

When the Hassle is Worth It

All those caveats probably beg the question: Why bother?

For investors just starting out or who have a small amount of their portfolios to devote to bonds (less than $100,000), the answer is, “Don't!” Just stick with a no-load, low expense mutual fund until you've amassed more.

But investors who do meet that criteria can use bonds to create a predictable income stream — something that no bond fund can guarantee.

Related >> A guide to mutual funds

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