Wait, Bonds Are Risky? Since When?

Gun to your head, what kind of bond would you buy?

If nothing came to mind, that’s ok. Bonds are tricky, but they are a topic that comes up again and again amongst investors – especially those craving safety.

In Short – What is a Bond?

A bond is a type of debt instrument. One person lends money to another, generally a corporation or governmental organization, which ties up the cash for a fixed amount of time. Bonds can be used by a variety of entities and organizations, such as local municipalities, public companies, national governments or banks, to raise money. In return for access to the cash, the debt-holder (entity who borrows the money) agrees to pay the creditor (entity lending the money) for the privilege. These payments are called ‘coupons’ and are often expressed as a percent of the ‘face value’ of the bond.

The face value of a bond, simply put, is the original price at which the bond is selling.

Okay, so those are the bond basics. At this point, you may be thinking: “That’s great, but how do I look at these original bond prices?”

Buying Bonds

Time for the ol’ good news/bad news bit.

Bad news: Always go for the bad news first. It’s called the bad news sandwich, and I guess this one’s open-faced.

The bad news is that the bond market is somewhat dark and foggy, not unlike walking into a Chinese opium den. There isn’t a centralized bond exchange – like the stock market – where prices are posted for any ole Joe to see.

Instead, bonds trade in the ‘over-the-counter’ market, or the ‘OTC’ market. Trading in OTC markets is done without the supervision of an exchange. You get cheated work with the dealer directly.

bonds

The good news: it’s getting better.

The advent of the internet means that a lot of transparency is being applied to the bond markets. There are many websites that offer prices on a wide range of bonds, so that regular investors can shop for the best price. Bloomberg is a great example.

If that feels too daunting, you can always work with a full-service broker to shop around for you. Otherwise, look up some discount online brokers with which you can sign up to compare prices. You might be surprised at the price differentials.

Umm…aren’t bonds supposed to be super safe?

Bonds can be safe, and bonds can be risky. Generally, owning bonds is safer than owning stocks, yes. Like with so many things in life, though, it’s a spectrum. If you own a high-yield corporate bond issued by Apple – well, Apple could go belly-up tomorrow and you could lose all or part of your hard earned cash.

Just a sec, what’s yield you ask? Glad you brought that one up.

The Yield of Bond

When people talk about the yield of a bond, they are generally referring to the term yield-to-maturity (YTM). The yield-to-maturity is the average annual return you can expect to realize by holding the bond to maturity, or to the end of its life span.

So, imagine you have a bond with a face value of $100 and it pays a 5% coupon yearly for 5 years. That means you are paid $5 every year plus you get your $100 back at the end. If at the end of 5 years, the bond’s price is still $100 then your coupon rate (5%) and your YTM are the same (5%). After all, if you earn 5% yearly for years, then your average annual return is 5%.

bond

Where YTM differs is that it takes into account the bond’s current price. So if that changes, if it deviates in any way from $100, then your YTM will change. It will no longer be 5%.

Right? So bonds can definitely be risky. Companies collapse all the time. Even government bonds carry some risk (errrrm…Argentina *cough cough*), even if U.S. Treasuries are often touted as being “risk-free”. If you buy a U.S. Treasury bond and interest rates rise, the price of the bond falls and if you sell, you will LOSE money. That’s a risk you have to bear. Of course you could always get around that by holding the bond to maturity.

Hold on, we just glossed over the fact that when interest rates rise, the price of a bond falls.

Imagine again that you own a bond with a face value of $100 and it pays a 5% coupon yearly for 5 years. We’ll call you Neo. You’ve literally just bought it but then all of a sudden, there’s a liquidity crunch and all the interest rates out in the world (this is very simplified, but bear with us) rise to 8%.

Picture yourself as a buyer of bonds in this environment, where companies are strapped for cash and are willing to offer 8% to people with the money to lend to them. Now you come across your other self, Neo who’s trying to offload a bond. He offers you a bond with a 5% coupon yearly for 5 years.

Would you, a buyer of bonds, buy that bond?

Hell no. Everyone else is offering you 8%. Now because you bought the bond and the coupon rate was agreed upon, it’s not like you can change that. Instead you negotiate on the only thing you can: the price of the bond. Thus, you offer him the bond at a discount. That’s why when interest rates go up, prices go down.

Bond Brokers…Yes or No?

You can always just go to a broker if all the above sends shivers down your spine, but be wary if a broker tells you that a trade is commission-free. The commission may be added to the purchase price, so the bond is artificially higher than it needs to be. Remember, it always pays to shop around!

Finally, there are generally minimum initial deposits for bond brokers, sometimes up to $5,000. If that seems too steep, then you can always look at investing into mutual funds that specialize in bonds.

Guys, do your research! Just as you would research a stock thoroughly you have to research the entity or corporation that is issuing you a bond to assess whether or not they are going to be able to pay you back. Try to think of it as a loan. Under what circumstances would you give someone a loan; and how can you apply that to the bond world?  Starting to think in that way might give you a sense of what risks you are willing to bear.

To learn more, head over to Wall Street Survivor.

 

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