An Overview of Bonds
Bonds Are Back: What You Need to Know
With disinflation and a major correction happening in the equities market, bonds are entering everyone’s scope of interest recently. While they might be the less flashy cousin of stocks, they’re still an important part of investment portfolios—especially in the current economic climate—and well worth understanding.
Bonds vs. Stocks
Stocks make you a shareholder, owning part of a company. Your returns depend on market performance.
Bonds make you a lender. You're essentially loaning money with stipulations on repayment and guaranteed interest.
Bonds are considered less risky than stocks due to the borrower's obligation to repay the debt. Stock performance is subject to market fluctuations, while bonds provide more predictable returns. On average, bonds yield approximately 5% annually.
What Is a Bond Coupon Rate?
Bonds pay back investors in regular installments, known as the coupon rate. For example, if a bond has a 5% coupon rate and a $1,000 face value, it pays $50 annually. At the end of the bond’s term (its maturity), you get back your original $1,000. The total earned over the bond’s life is called the yield to maturity.
Bond Pricing and Current Yield
While the coupon rate remains fixed, the current price of a bond can fluctuate. This affects its current yield, which is calculated as the coupon rate divided by the bond's current market price.
Example: A $1,000 bond with a 5% coupon drops in price to $500. The $50 interest now represents a 10% yield on the new price.
Bonds can be sold on the secondary market, or repurchased by the original issuer.
What Affects a Bond’s Coupon Rate?
There are two primary factors:
Credit Quality – Just like people, corporations and governments have credit ratings from agencies like Standard & Poor’s, Moody’s, and Fitch. A lower credit rating means a higher risk of default—and a higher interest rate to compensate for that risk.
Time to Maturity – The longer a bond takes to mature, the more risk it faces from inflation and interest rate changes, which typically leads to higher interest rates.
Types of Bonds
U.S. Treasury Bonds – Considered the safest, with virtually no risk of default.
Corporate Bonds – Vary in risk. High-yield (junk) bonds carry high default risk but offer higher returns. Investment-grade bonds are safer with lower yields.
Municipal Bonds – Issued by states and cities; may offer tax benefits.
Agency Bonds – Issued by government-affiliated organizations like Fannie Mae.
Why Bonds Matter Right Now
Bonds are making a comeback because of how they respond to interest rates. When interest rates go up—as they're expected to this year with Fed tapering and shifting economic policies—bond prices fall. This inverse relationship helps balance out portfolios during rate hikes.
Need Help Navigating the Bond Market?
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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and do not constitute financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.