Bond Basics for the Right-Brained

By The Advocates

When I was in banking, I only knew bonds as EE Bonds that could be redeemed at my teller counter, often requiring a managerial assist to complete the redemption. That’s me; I was the manager. And my bond experience was limited to overriding teller transactions.

Bonds are deceptively simple. You buy them for a specific dollar amount, term, and pre-determined interest rate, much like CDs. They’re complex too, however, so complex that people in the industry insist the smartest guys on Wall Street are not working in stocks, but bonds. We won’t get to that level today.

I’ve been tasked, by Kurt, with explaining bonds in a way that makes sense to right-brained folks like me. Its probably a good idea because next week will see us tackling certain bond philosophies. It couldn’t hurt to brush up on the basics.

Bond Basics

We’re talking today about individual bonds. There are other ways to buy bonds, but we’ll put a pin in that until next week.

Governments and corporations issue bonds to raise money for stuff they want or need to do. As a buyer, you become a lender of sorts. Issuers pay you back the face value of the bond plus interest, much like any other loan. Simply collect your interest payments, wait for the maturity date, and retrieve your principal, if you like. Bonds can also be traded before maturity, more on that later.

Like human borrowers, bond issuers are rated by credit agencies with varying degrees of accuracy and reliability. Properly done, a bond’s rating should reflect the issuer’s financial health and ability to repay their debts, something to strongly consider when evaluating how much risk you’re willing to take as a buyer/lender.

Bond prices fluctuate. Your purchase price no longer matches the face value of the bond after you’ve bought it. It’ll be above or below it, depending in part on what prevailing interest rates are doing. 

Interest rates (“yields”) and bond prices tend to have an inverse relationship. Declining rates on new bonds can make existing bonds with higher yields more valuable on the market and vice versa. Recent rate hikes have seen bond prices trending down.

Primary and Secondary Markets

When you buy a bond from the issuer directly, whether that’s a government or corporate entity, you’re participating in the primary market. There exists a secondary market where investors trade bonds among themselves. If you want to sell your bond before maturity, this is where you’d go.

Bond buyers of all kinds (including the US government!) hit up the secondary markets to trade bonds and invest cash according to their respective purposes. Sellers go there for a variety of reasons: they need cash (liquidity), they want to take what they’ve earned so far (realized capital appreciation), or maybe they don’t like their bond issuer anymore (credit rating issues, probably). Either way, secondary markets tend to be efficient and have close to fair value pricing for whatever they’re trading.

To Bond, or not to Bond

Bonds are usually bought as defensive positions because they are generally safe and reliable. For the more risk-averse among us, that’s attractive. Even moderate-plus folks use them to counterbalance volatility that tends to come with their cousin, the stock market. Reliable is, however, not the same as infallible. Issuers can develop or worsen existing issues, which could impact their ability to repay principal and/or make your interest payments.

With some exceptions, the trade-off for the safety of bonds is lower returns. Buyers need to be aware of FOMO, that is the “fear of missing out” on higher returns. They’ll also find it harder to change strategy in the name of FOMO or something else because bonds are less liquid than other investments. Even on the secondary market, bonds are usually traded with more rigmarole than other securities.

Feeling refreshed? I hope so. See you next week when dive into our preference for bond funds over individual bonds in most cases.