Today's episode of “Saving and Investing” moves us from the introductory material to the details of common investments. To begin, Michael Fischer explains bonds:
What is a bond? (2:38)
This video left me wanting more. Bonds, like leverage, have been a blank spot in my financial education. I've never owned a bond, nor has anyone in my family. Fortunately, Fidelity Investments has an excellent primer on how bonds work.
The basics as I understand them are these: a government or corporation issues bonds to borrow money from investors. A bond is generally issued with a $1000 face value. The first person to buy the bond pays some amount of money (not always $1000), and the issuer promises pay $1000 to repurchase the bond when it matures. (Bonds can be issued for nearly any length of time, though certain periods are more common than others.) After its initial purchase, the bond can be bought and sold on the open market, and may trade for more or less than the initial price.
A bond is issued with a particular interest rate. (The interest rate is also called its “coupon rate” because bondholders used to redeem physical coupons in order to collect the interest payments.) The bond issuer pays this interest rate at specified intervals. For example, if a $1000 bond is issued with a 5% coupon rate, it pays $50 interest each year, which might be paid in $25 installments every six months.
Bonds are rated based on their quality, or the likelihood that they'll be repaid. The highest-rated bonds are those with the least risk, and therefor the lowest
interest rates yields. The lowest-rated bonds are the so-called “junk bonds”, which offer high returns but come with exceptional risk.
There's much more, of course — I'm completely avoiding the concept of yield — and if you're interested, I encourage you to read the Fidelity primer.
Why would anyone buy bonds if they offer lower returns than stocks? Bonds offer less risk than stocks. As part of a diversified investment portfolio, they offer a safety net in times of a bear market. Bonds also appeal to those who require a regular income from their investments. Stocks may appreciate, but they don't actually provide income until you sell them. (An exception, of course, is stocks that pay dividends. Unsurprisingly, bonds and dividend-producing stocks appeal to the same sorts of investors.)
Your Money or Your Life, one of my favorite personal finance books, promotes investing in U.S. government Treasury bonds as a step toward financial independence. (The goal being to acquire risk-free income-producing assets, and then to live exclusively off that income.) At current yields, however, one would need around $1,000,000 in Treasury bonds in order to pursue this sort of plan. (YMOYL was written in the 1980s when yields were significantly greater.)
Bond trivia: Singer David Bowie issued bonds secured by his music royalties. He used this $55 million cash infusion to buy back song rights from a former manager. Neat!