The Basics of Bonds

Tomorrow morning, Get Rich Slowly will feature a guest post about how bonds work. Bonds don't get a lot of press. They're not as sexy as stocks, and many beginning investors simply ignore them. (I know that has certainly been true in my case.) Before tomorrow's story, though, I wanted to take some time to review the basics of bonds.

When you buy stock, you are buying a piece a company, but when you buy a bond, you are loaning money to an organization. Governments and corporations issue bonds to borrow money from investors. (For more on this topic, please review the difference between debt and equity.)

A bond is generally issued with a $1000 face value (also known as “par 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. (Here's more on the relationship between prices, rates, and yields.)

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 yields. The lowest-rated bonds are the so-called “junk bonds”, which offer high returns but come with exceptional risk. “Investment-grade” bonds offer lower long-term returns than stocks.

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 often appeal to the same sorts of investors.)

There's much more to know about bonds, of course, but these are the basics. If you're interested, I encourage you to read the Fidelity primer on bonds — and come back for tomorrow's discussion of how bonds work! (You may also want to check out Treasury Direct, the U.S. government site devoted to bonds.)

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DebtGoal
DebtGoal
11 years ago

Bonds are clearly excellent financial tools. Many who struggle with personal debt need to restructure their investments to include lower-risk asset classes, including bonds. For those that have strong disincentives to cash out their investments for the purposes of debt reduction payments, what role should bonds play in, say, their retirement portfolios? Is advice for them any different from advice for those who don’t revolve non-mortgage debt from month to month?

Courtney
Courtney
11 years ago

YAY!! I have been contemplating buying bonds for weeks now, and I was hoping and hoping you would post some advice! 🙂

Looking forward to tomorrow’s post!

Josiah Garber
Josiah Garber
11 years ago

Bonds can be particularly risky when there is a threat of higher than normal inflation. ie. right now.

This is because you may gain dollars, but lose value.

Anne
Anne
11 years ago

There was a really fun article in the New York Times a bit back about bonds that I actually found to be a rather helpful lesson.

It’s about 135 year old bonds finally maturing.

http://www.nytimes.com/2009/02/13/nyregion/13jerome.html?_r=1&scp=10&sq=bond+new+york+horse+&st=nyt

Kristen@The Frugal Girl
[email protected] Frugal Girl
11 years ago

My kids have a couple of government savings bonds, but that’s the limitation of my exposure to bonds. I’m looking forward to tomorrow’s post!

Tim
Tim
11 years ago

Nice intro. Keep in mind that the during the current financial crisis, while the value of stocks plummeted, the value of many types of bonds did as well, and did so before the stock market. (US Treasury bonds, on the other hand, the safest of the safe, generally increased in price.)

joy
joy
11 years ago

When my in-laws asked if they could contribute to an education fund or purchase bonds for my son, I decided I wanted to have bonds because it was something I was familiar with growing up. My dad had purchased me a good amount of bonds which ended up paying for my college. At the time, we had not established an education fund for our son and, truthfully I was wary of them. My FIL decided to buy face-value bonds which was purchased at 100 percent value (not sure if it is actually called that). His other grandson, the parents had… Read more »

PDXGirl
PDXGirl
11 years ago

Yay! I’m learning about bonds in my accounting class this week, how very timely.

I’ll be sure to check in tomorrow 🙂

WilderMiss
WilderMiss
11 years ago

I understand what bonds are and how they work, what I can’t figure out is the best way to buy them (corporate specifically). Hopefully tomorrow’s post will help. If not, I’d suggest that for a future post topic.

Meagan
Meagan
11 years ago

My grandmother always used to buy my cousins and I $100 government bonds for Christmas and our birthdays along with small gifts.

Growing up it wasn’t something to look forward to it was more “Yea, I can buy something good… in 7 years.”

They matured in the years leading up to me entering University, and nearly paid for half of my first year tuition. I was grateful for them as I am paying for my school myself.

Looking forward to tomorrows post!

Justin
Justin
11 years ago

Great intro on the basics of bonds. As the stock market continues to ride the roller coaster, bonds continue to look more appealing.

Shadox
Shadox
11 years ago

I would just like to point out that not all bonds are safer than stocks. So-called “junk bonds” often offers much higher returns and greater risk than stocks do.

Trevor @ Financial Nut
Trevor @ Financial Nut
11 years ago

It’s nice to go back to the basics. Thanks, JD.

bigbuddha
bigbuddha
11 years ago

To anyone looking at purchasing Government bonds. Please look into the extreme inflationary effect that goverment bonds have on you and the economy. Issuance of government bonds will eventually lead help economies go down the path of massive inflation. inflation being the destroyer of real wealth and a covert government tax.

Sandy
Sandy
11 years ago

I started buying Treasury EE bonds a few years ago. I had it deducted from my paycheck automatically for about a year. Now that you mention it I just remembered that they exist! I hear that my state (NY) is issuing municipal bonds and I am interested in purchasing some but don’t know how to start or wher to go. Any tips?

Hausfrau
Hausfrau
11 years ago

I was talking to my husband about bonds right before I logged onto the site, and what do you know? GRS was on top of it! I have been wondering why people aren’t buying more bonds. Wouldn’t that help rebuild the governments coffers as well as showing pride for the country? I know Bonds aren’t as sexy as stocks, but that seems like a win-win for us and the government.

AppleMan
AppleMan
11 years ago

@#14
The issuing of government bonds isn’t the direct cause of inflation-it’s caused by the Federal Reserve. “Helicopter Ben” Bernanke is printing digital money and using it to buy the bonds. This extra money is making all of our dollars worth less.

DDFD at DivorcedDadFrugalDad
DDFD at DivorcedDadFrugalDad
11 years ago

As you mentioned they are often overlooked, but they do have a place in every portfolio . . .

Charlotte
Charlotte
11 years ago

JD, you did not mention that there are also bond index funds. It may be a good option for some people.

Paul in cAshburn
Paul in cAshburn
11 years ago

I believe we are in for inflation, and rising interest rates. That’s just an opinion, and it’s possible that we won’t have inflation and interest rates will stay low for a long time. But, if you think inflation and rising interest rates are more likely – stay away from long term bonds (anything over 3 years). If you must buy bonds, buy TIPS or I-Bonds. Just my humble opinion.

Paul in cAshburn
Paul in cAshburn
6 years ago

Just goes to show how wrong I can be. Interest rates are still being held artificially low by the Fed. Safe strategies cost money sometimes.

Josiah
Josiah
11 years ago

I agree Paul, we shouldn’t think 1 dimensionally. People could get burned real bad on bonds.

Joe
Joe
11 years ago

Can anyone explain to me when an electronic EE bond would be better than a paper EE bond? Thanks.

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