What you need to know about bonds

May 3, 2013  | By Kevin Smith

I often joke that few people I meet have a strong understanding bonds because 1) bonds are boring and 2) bonds are complicated. ‘Boring and complicated’ don’t make for good movie scripts, book plots, or cocktail hour conversations.

My objective is for you to know enough about bonds to be understand how they might be appropriate for you and their major risk characteristics.

When you hear the word “bond”, think “loan”

When you buy a bond, you are actually making a loan. You can loan money to a company (Corporate Bond) or a government entity (Treasury and Municipal Bonds). Your bond is just like a loan in that it pays interest rate over some period of time and you get your investment back at the end of that period. Here is an example of a bond you might buy from Dell.

Issuer: Dell
Face Amount: $1,000
Maturity: 5 years
Interest Rate: 5%, paid semi-annually

This means you lend Dell $1,000 for 5 years. Dell pays you $50 (5% X $1,000) every 6 months for 5 years and sends you the initial investment back at the end of the 5 years.

This is a basic example, but the terms of the bond can become much more complicated. It is most important that when you think ‘buying a bond’, you then think ‘making a loan’.

Inflation decreases your purchasing power

Inflation is a difficult concept. It means that your dollar bill will buy you slightly less stuff next year than it buys you right now. This is because prices inflate. The most basic explanation I can provide for inflation is to think of more dollars chasing after the same amount of goods and services. The interest rate referenced in a bond is called a ‘nominal return’, meaning that it does not account for inflation. The ‘real return’ does account for inflation.

If you start the year with $1,000 in the bank and inflation raises prices 3% that year. You are able to buy 3% fewer goods and services with you $1,000 at the end of the year. If instead you invest your $1,000 in a bond that matures in one year and pays 3% interest, you will end the year with $1,030. You earned 3% while your purchasing power declined by 3%. In this scenario, you are able to buy the same amount of goods and services as when you started the year. As an investor, you should be interested in ‘real returns’, which account for inflation. As a rule of thumb, take the going interest rate on a bond and subtract the going inflation rate. For example, at the time of this post:

1.81% 10-Year U.S. Treasury Bond
1.40% Inflation Rate
0.41% Real Interest Rate

Interest rates go up, bond prices go down

This is a little more complicated. The best way I can explain this important concept is by using an example.

1) You buy a bond
Let’s assume today you buy a $1,000 bond from Dell that pays 5% per year for 5 years. Dell agrees to pay you $50 each year and return your $1,000 at the end of 5 years.

2) The financial conditions of your bond issuer change
Let’s suppose that next week Dell loses a major government contract which made up 5% of their total sales. As a result, there is a greater risk that Dell will not be able to make interest payments to their bond holders. Now let’s pretend that the following week Dell decides to expand further into the cloud computing market by buying data storage companies. They need $500 million to do this and decide to raise the money selling more bonds.

3) Interest rates go up
However, because of the lost revenue and the risk of expanding into a different market, investors are no longer willing to buy their bonds for 5% interest. Investors perceive more risk in buying Dell bonds and now demand a 7% interest rate for the same $1,000 5 year bonds.

4) Your bond price goes down
What does this mean for you, the owner of a 5 year Dell bond paying 5% interest? If you needed an emergency transmission repair and had no choice but to sell your bond to raise cash, who would want to pay you $1,000 for your 5% bond when they can buy a new bond paying 7%?

The answer is someone would buy your bond, but not for $1,000. You would receive an offer for something less than that, for example $900. The reason is that the buyer pays $900, continues to receive the $50 interest payments each year, and receives the full face amount of $1,000 at the end of 5 years.

What happened? The going interest rate went up and the bond price went down. When subsequent investors can find better deals on bonds than what yours offers, your bond will become worth less. The opposite is true if interest rates go down. In this situation, your bond becomes more attractive and investors are willing to pay a premium for it (more than you paid for it).

Considering that interest rates are at historic lows, many investors are concerned that interest rates will inevitably go up and the values of their bonds will fall. This is a legitimate concern. I will address managing interest rate risk in future posts.