Bonds
What are bonds?
A bond is a debt instrument in the form of a loan given by an investor to a borrower such as a company or government. These entities issue bonds as a way of raising money to fund expenses or new projects. A company or government will issue a bond as a means of borrowing money, and in turn, an investor (or bondholder) receives interest payments on this loan, plus repayment of the principal investment.
The bond market is a component of the credit market. Unlike stocks, bonds are not traded publicly and there is no central bond exchange. To a certain degree, the bond market is regulated by the Financial Industry Regulatory Authority (FINRA), which is a corporation that operates as a self-regulatory authority (SRO). FINARA’s Trade Reporting and Compliance Engine (TRACE) reports bond trading prices and volumes. It is important to understand that there is not the same level of transparency in bond trading, as there is with stock trading.
In general, bonds usually possess lower volatility and are often regarded as a safer investment than stocks, for instance. However, it is crucial to understand that bond trading is speculative, has the potential for significant financial loss, and is NOT appropriate for all investors.
How do bonds work?
Say Town X wants to construct a new bridge as part of its infrastructure initiative. Therefore, it decides to issue bonds as a way of raising funds for the bridge project. Each bond is a loan with a face value of $1,000, which Town X promises to may back in 10 years (referred to as the maturity date). The town will pay an interest rate (known as the coupon rate) of 5% annually on each of the issued bonds.
You, the investor, decide to purchase one of these bonds for the face value of $1,000. With each passing year, Town X pays you, the bondholder, $50 in interest payments (called the coupon) on the bond. When it reaches its maturity date of 10 years, you redeem the bond, and Town X returns your principal investment of $1,000.
The advantage of bonds for investors is the regular interest payments, in addition to the return of the principal. However, it is crucial to understand that there are disadvantages to investing and trading in bonds. A major drawback of investing and trading bonds is the potential for “default risk” – when the issuer of the bond (be it a company, etc.) is unable to pay back the principal. Usually, bonds that have a higher coupon rate (or interest rate), likewise, come with higher default risk.
Bonds are classified as either “investment-grade” or “high-yield”, based on their credit rating. Investment-grade bonds receive AAA, AA, A, and BBB ratings. Conversely, high-yield bonds (or junk bonds) are rated BB or lower, because despite offering higher yields, they come with higher default risk.
There are a couple of ways an investor can profit from investing in bonds. Firstly, is to hold the bond until its maturity date, collecting the interest payments as outlined in the above example. The other method is to sell the bonds at a higher price if the market value increases. There are two factors that contribute to a rise in the price of a bond. If there is an improvement in the creditworthiness of the issuer, then usually the bond price will increase. Additionally, if interest rates lower, then the market value of existing bonds with a higher coupon rate increases.
Types of Bonds
Corporate Bond – This is a bond issued by a company to fund expenses and operations. Corporate bonds usually have a higher coupon rate, because corporations represent a higher default risk.
Government Bond – This is a bond issued by a government to fund expenditure, and is also referred to as a “Treasury bond”. Government bonds receive the highest rating of AAA, and are considered the safest bond investment because they are issued by a national government.
Municipal Bond – This is a bond issued by a state or local government to fund expenditure. Some varieties of municipal bonds come in tax-exempt formats making them appealing to investors. Municipal bonds are often referred to as “munis”.
How to invest in bonds?
If you are interested in investing in bonds, as with any investment vehicle, it is essential to research and do your due diligence prior. There are a few ways that an investor can invest in bonds: through a broker, via a bond exchange-traded fund (ETF), or from the US government.
Because there is no central bond exchange, it can prove more difficult for bond investors to know whether they are getting a fair price on a specific bond. FINARA’s Trade Reporting and Compliance Engine (TRACE) is an indispensable resource for investors by reporting bond trading prices and volumes, thus regulating the bond market to a certain degree.
Bond exchange-traded funds (ETFs) invest solely in bonds, be they government bonds like US Treasuries, corporate bonds, or municipal bonds. An advantage of these specific ETFs is the fact that interest is paid out each month with a dividend, rather than every six months which typically transpires with an individual bond.
If you are interested in specifically investing in government bonds, the US Department of the Treasury offers its TreasuryDirect program, which enables investors to buy and redeem bonds directly from the department online.
Best Online Bond Brokers
Fidelity
Fidelity is a popular choice for investors who want access to a variety of bonds, be it individual bonds, bond ETFs, or bond funds. In addition, Fidelity offers comprehensive research tools and trading data, plus bond market news and issuer data.
Charles Schwab
Charles Schwab is another popular choice for investors. The company offers an array of individual bonds, bond mutual funds, and bond ETFs. It offers market analysis, tools and resources for self-directed investors, as well as guidance from fixed income specialists.
E*Trade
E*Trade is a good choice for investors who want professional guidance, in addition to access to comprehensive research tools and market data that is intuitive and user-friendly. This company offers investors access to over 50,000 bonds.
Bond Trading Simulator
If bonds are something that you are interested in, give this free simulator a try before leaping into the real-world bond market. It’s fun and informative and will help you hone valuable skills and techniques to become an effective trader.
Comparison Table On The Different Types Of Trading
Here is a comparison table examining the different types of trading.
Type of Trading Best Suitable For Risk vs. Potential Return Control Over Investments Research and Legwork Needed
Options Active Traders Lower-level Risk
(When Done Correctly)The investor has complete control over which companies are selected, and what options contracts are chosen. All research and trading is done by the investor.
Stocks Beginners and Long-term Investors High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
ETFs Beginners and Long-term Investors Lower-level Risk Professionally managed investment vehicle. All research and trading is done by a financial professional. Investors are charged a fee called an "expense ratio".
Bonds Beginners and Long-term Investors Lower-level Risk If investing in individual bonds (rather than bond ETFs) the investor has direct control over all invest decisions. All research and trading is done by the investor, if investing in individual bonds.
Mutual Funds Beginners and Long-term Investors Lower-level Risk Professionally managed investment vehicle. All research and trading is done by a financial professional. Investors are charged a fee called an "expense ratio".
Futures Active Traders Medium-level risk (when done correctly) The investor has complete control over which futures contracts are chosen. All research and trading is done by the investor.
Swing Trading Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Day Trading Active Traders High risk, yet has the potential for larger gains if done correctly. The investor has direct control over all invest decisions. All research and trading is done by the investor.
Commodity Trading Beginners and Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Trend Trading Beginners and Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Bonds FAQs
What types of bonds are available to investors?
There are three main types of bonds available to investors:
Corporate Bonds - These bonds are issued by a company to fund expenses and operations. Corporate bonds usually have a higher coupon rate, because corporations represent a higher default risk.
Government Bonds - These bonds are issued by a government to fund expenditure, and are also referred to as a “Treasury bonds”. Government bonds receive the highest rating of AAA, and are considered the safest bond investment because they are issued by a national government.
Municipal Bonds - These bonds are issued by a state or local government to fund expenditure. Some varieties of municipal bonds come in tax-exempt formats making them appealing to investors. Municipal bonds are often referred to as “munis”.
How to buy bonds?
There are a few ways that an investor can buy bonds: through a broker, via a bond exchange-traded fund (ETF), or from the US government.
Because there is no central bond exchange, it can prove more difficult for bond investors to know whether they are getting a fair price on a specific bond. FINARA’s Trade Reporting and Compliance Engine (TRACE) is an indispensable resource for investors by reporting bond trading prices and volumes, thus regulating the bond market to a certain degree.
Bond exchange-traded funds (ETFs) invest solely in bonds, be they government bonds like US Treasuries, corporate bonds, or municipal bonds. An advantage of these specific ETFs is the fact that interest is paid out each month with a dividend, rather than every six months which typically transpires with an individual bond.
If you are interested in specifically investing in government bonds, the US Department of the Treasury offers its TreasuryDirect program, which enables investors to buy and redeem bonds directly from the department online.
How are bonds rated?
Credit rating agencies such as Standard & Poor’s (S&P), Fitch Ratings, and Moody’s provide credit rating data for companies and their respective bonds.
Bonds are classified as either “investment-grade” or “high-yield”, based on their credit rating. Investment-grade bonds receive AAA, AA, A, and BBB ratings. Conversely, high-yield bonds (or junk bonds) are rated BB or lower, because despite offering higher yields, they come with higher default risk.
What are municipal bonds?
Municipal bonds are issued by states or municipalities to fund expenditure. They are often referred to as “munis”. Some varieties of municipal bonds come in tax-exempt formats making them appealing to investors.
How do bonds make money for investors?
There are a couple of ways an investor can make money from investing in bonds. Firstly, is to hold the bond until its maturity date, collecting the interest payments as outlined in the above example. The other method is to sell the bonds at a higher price if the market value increases. There are two factors that contribute to a rise in the price of a bond. If there is an improvement in the creditworthiness of the issuer, then usually the bond price will increase. Additionally, if interest rates lower, then the market value of existing bonds with a higher coupon rate increases.
Why might a town decide to issue bonds?
A town might decide to issue bonds to fund expenditure - For example, an infrastructure initiative such as building a bridge.
What happens when a bond becomes due?
When a bond becomes due, this is known as the maturity date. At the maturity date, the issuer must pay back the original face value of the bond to the investor in its entirety. Therefore, the investor is getting a return on the principal investment.
Bonds vs. Stocks
Bonds are debt instruments in the form of loans given by investors to borrowers like companies or governments. A company or government will issue a bond as a means of borrowing money to fund expenses or new projects. In turn, an investor (or bondholder) receives interest payments on this loan, plus repayment of the principal investment.
A stock is a security that represents fractional ownership in a company. By purchasing stocks, an investor is buying a portion of a specific company, and therefore entitled to a fraction of said company’s earnings in the future. These specific fractional portions of a company are deemed “shares”. By buying shares (or stock, as it were) in a company, the investor becomes a “shareholder” in the company. Typically, companies sell shares of their stock to generate profit.
How to cash in savings bonds?
The easiest way to cash in savings bonds is at a financial institution. Additionally, you can cash in your savings bonds via the US Department of the Treasury’s TreasuryDirect website, which enables investors to buy and redeem bonds directly from the department online.