Bonds have always been ignored as the boring cousin of stocks. Yet, all it takes is a bear market to show the value of a bond's relative stability, and most managers will tell you that a good portfolio should be at least partially diversified with bonds.
At the most basic level, bonds are an IOU. Sometimes, companies and governments need an infusion cash for projects at a scale far larger than what most banks can lend. Therefore, they issue bonds to investors in which each individual investor becomes a lender.
However, one of the most fundamental concepts in finance is the time value of money, or that money today is worth more than money tomorrow. To compensate, investors demand a premium in the forms of interest payments. The fact that investors know the exact amount they will receive from a bond is why bonds are often referred to as fixed income securities.
While it is generally accepted that over time, the average return of stocks outpaced the average returns on bonds, the fact of the matter is in the short-run, bonds are far safer and for those with a shorter time horizon or less able to take on risk, bonds are a safer way to invest.
For bonds, the face value or the par value is the amount the holder of a bond will receive when the bond reaches its maturity date. Often times, investors will mention 30-year Treasuries or 10-year Treasuries, the difference being the maturity date. However, the tricky aspect of bonds is that the face value is not the actual price of the bond. A bond's price is set by the market due to various factors.
The coupon, or the interest rate, is what a bondholder will receive as compensation for loaning money. Some bonds pay interest biannually, but some also pay monthly or annually. The general rule, and rarely are there exceptions, a bond with a shorter maturity date will have a small yield (explained later) because of the less risk due to time.
As mentioned earlier, bonds are publicly traded like other securities. Because of this, the price of bonds will often differ from the face value, the yield, or the return on a bond, will often differ from the interest rate.
For example, if the face value of a bond is $1,000 with a 10 percent interest rate, the yield is just 10 percent ($100/$1,000). However, if the price of the bond falls to $500, then the yield jumps up to 20 percent ($100/$500).
Therefore, it then follows that the yield of a bond moves opposite to its price.
The price of the bond can be affected by many factors, but the main factor is the interest rates of the economy. In the U.S., if the Federal Reserve raises interest rates, the interest rates of newer bonds have to rise to entice investors and older bonds must rise to keep in line with newer bonds.
In terms of risk, government bonds are seen as the safest, with some viewing them as effectively riskless. Municipal bonds are seen as the next safest, with corporate bonds the riskiest of the bonds. The risk in bonds comes from the issuer of the bond defaulting on its obligations. Bonds with a high risk and therefore high yield are what are famously known as junk bonds.
While bonds are seen as stocks with no sex appeal, a risk-seeking investor can still find plenty of action in the world of bonds. Other than being a vehicle to diversify a portfolio, savvy investors have struck it rich in the realm of junk bonds.
