Broker Check

How Bonds Work

| November 16, 2016

Executive Summary:

  1. Raise your predictable monthly income with individual bonds
  2. Individual investment grade bonds provide stable income
  3. When an investment grade bond matures, the investor’s principal investment is returned to her / him … unless a bond defaults. 
  4. Investment grade bonds are not risk-free, but the risk of default is considered low in my professional opinion.  (Also see below for more on that.)
  5. If you are receiving a pension and / or Social Security and / or annuity income payment ... you might not need to take very much risk. 
  6. And you might be able to generate higher stable income than you are currently receiving from CDs or Money Market.

Disadvantages & Advantages:

(NB: The Disadvantages & Advantages of Bonds, along with the Executive Summary above -- have been written by me – Bruce Mazo.  The remainder of this post about bonds are direct verbatim quotes from Investopedia … with the URLs shown.)

In one of my own previous blog posts   I stated the Disadvantages & Advantages of Bonds … 

Disadvantages of Bonds

  1. “Low current interest rates
  2. Little inflation protection
  3. Limited growth potential
  4. Possible market loss before maturity”

Advantages of Bonds

I also have previously stated that bonds have the following Advantages:

  1. “Principal Safety
  2. Stable Income
  3. Return of principal at maturity
  4. Liquid
  5. Safe – conservative – but not guaranteed”


 What is a 'Bond?'

"A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer."


How Bonds Work

"When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate (coupon) that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date).

The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time."



"Bonds are commonly referred to as fixed-income securities and are one of the three main generic asset classes, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded on exchanges, while others are traded only over-the-counter(OTC)."



"Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the market price of the bond will fluctuate as that coupon becomes desirable or undesirable given prevailing interest rates at a given moment in time. For example if a bond is issued when prevailing interest rates are 5% at $1,000 par value with a 5% annual coupon, it will generate $50 of cash flows per year to the bondholder. The bondholder would be indifferent to purchasing the bond or saving the same money at the prevailing interest rate.

If interest rates drop to 4%, the bond will continue paying out at 5%, making it a more attractive option. Investors will purchase these bonds, bidding the price up to a premium until the effective rate on the bond equals 4%. On the other hand, if interest rates rise to 6%, the 5% couponis no longer attractive and the bond price will decrease, selling at a discount until it's effective rate is 6%.

Because of this mechanism, bond prices move inversely with interest rates."


Characteristics of Bonds

"Most bonds share some common basic characteristics including:

  • Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond issuer uses when calculating interest payments.
  • Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.
  • Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon payments.
  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds.

Two features of a bond –credit quality and duration – are the principal determinants of a bond's interest rate. If the issuer has a poor credit rating, the risk of default is greater and these bonds will tend to trade a discount. Credit ratings are calculated and issued by credit rating agencies. Bond maturities can range from a day or less to more than 30 years. The longer the bond maturity, or duration, the greater the chances of adverse effects. Longer-dated bonds also tend to have lower liquidity. Because of these attributes, bonds with a longer time to maturity typically command a higher interest rate."

Investment Grade vs. Non-Investment Grade

The credit scores established by the ratings agencies can be grouped into two categories: investment grade and non-investment grade, or junk. Investment-grade debt is consider to have low default risk and is generally more sought-after by investors. Conversely, non-investment grade debt offers higher yields than safer bonds, but it also comes with a significantly higher chance of default.

While the grading scales used by the ratings agencies are slightly different, most debt is graded similarly. Any bond issue given a AAA, AA, A or BBB rating by S&P is considered investment grade. Anything rated BB and below is considered non-investment grade.



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