How Bonds Work

9 Key Points to Better Understand Bonds

Out of all of the investment conversations I have with my clients, it seems that most of them don’t understand what bonds are and how they could fit into their portfolio.

Do You “Get” Bonds?

1. A bond is debt. When you buy a bond, you lend your money for a specific period of time to someone, and they pay you interest in return. You are a creditor. At the end of the term, you get your money back, and you received the interest along the way.

2. The interest you receive is usually paid twice a year.

3. The interest rate you receive is fixed. But how much of that interest do you really keep after inflation? Let’s say the rate that you receive on a bond is 5.00% and the inflation rate when you bought the bond is 2.00%. So on a real basis, you are making only 3.00%. (to keep it simple we will not include taxes). So the money you receive (the rate you get) gets eroded by inflation.

4. But what happens when inflation rises? If inflation rises to 4.00% in the example above, than what you are really making is just 1.00%. One of the most important factors that dictate whether bond prices go up or down is the rate of inflation, and the markets perception of the future direction of inflation. This is what can cause interest rates to go up or down.

5. Inflation and interest rates usually move in the same direction. So if inflation increases, than interest rates usually go higher. Sometimes interest rates go up if the market thinks that their will be inflation sometime down the road.

6. In point #1 we talked about lending money. It’s important to understand who you are lending your money to, and whether they are financially strong enough to pay you your interest twice a year and pay you your money back. So how do you judge and measure the financial strength of a company? There are 2 credit rating agencies that rate the borrowers’ ability to pay you back. They are S&P and Moodys.

7. The longer the term of the bond you buy, the higher the rate is (usually). But remember the payment is fixed. So if you buy a bond at a low rate, and inflation and interest rates go higher, than you are stuck holding a bond that pays a below market rate. If you hold your bond till maturity, than you will get your money back regardless of what happens to interest rates. You could sell your bond before the term expires, but you will most likely get less than what you paid for it if interest rates go higher.

8. Sometimes bonds can go up or down in price due to the law of supply and demand.

9. So how do bonds fit into your portfolio? Stay tuned for next week. We’ll give some specific examples of when you would want to buy bonds, how to buy them, etc.