What Is a Bond? And Why Should You Care?

My favorite Bond is James, not to be confused with the ornithologist(look it up) of the same name. And, while I treasure my bonds with family and friends, they are not Treasury bonds. So, while you choose between reading on or scrolling to the next cat video, here is why you should care what a bond is: You undoubtedly own some or parts of them and you should know what they are and what they do. First, let’s talk about you.

Bond Mutual Funds:

Most of us own bonds within a mutual fund that pools investors’ money and purchases multiple types of bonds for our investment purposes. The mutual fund diversifies our bond holdings, helping to reduce our investment risk.

What is a bond?:

Companies, governments and colleges and universities often sell bonds to raise money for purposes like constructing buildings or for general operating purposes. When those entities sell or “issue” bonds they are borrowing money for a set period of time. In return, the purchaser of the bonds gets paid periodic interest payments called “coupons” plus a promise to receive back the full amount of what they loaned at the “maturity” of the bond. That coupon payment is expressed as a percentage and can be referred to as the bond’s yield. For instance, if the face amount of your bond is $1,000 and the annual coupon payment is $40, then the bond’s yield is 4% per year.

Bond buying is sometimes called “fixed-income” investing since the periodic coupon payments, usually twice a year, never vary in amount during the term of the bond. Terms of bonds can range from just a few months to 30 years, sometimes longer.

Benefits of bonds:

Bond benefits are two-fold: 1) The regular coupon payment provides steady income; 2) Their prices usually don’t fluctuate nearly as much as stock prices do. This is why older investors often hold a higher percentage of their portfolios in bonds or bond mutual funds so as to avoid the risk of widely fluctuating values of other asset classes, such as stocks.

Bond risks:

First, if inflation is higher than the coupon payment, then your investment is effectively losing ground. For instance, if inflation is 3% annually and the yield of your bond is 2.5% per year, you lose .5% percent of purchasing power each year.

Second, if interest rates rise higher than your bond’s yield, the bond’s value will decrease if you were to sell it. For instance, back to our original example, if interest rates rise you will still receive that 4% annual payout but, if you try to sell your bond before it reaches maturity, the market value will have declined below the original value of $1,000. If you keep the bond to maturity, however, the bond issuer will still pay you the full $1,000.

Note: If you’ve ever heard that bond yields and prices move in opposite directions, this is why.  

Note 2: U.S. Treasury bonds are deemed risk-free investments as they are backed by the full faith and credit of the U.S. government. 

I have been asked three times recently what a bond is so decided a primer might be helpful to others as well. So now, if you’re ever asked what a bond is, you won’t feel shaken or stirred.

Steve Byars, CFP®