Financial Instruments – A Primer On Bonds

Most people over the age of forty have money invested in the stock market. Many of them have limited their participation to mutual funds, 401(k)s, and managed IRAs and may not fully understand the underlying investments they hold through those means. Investors who control their investments directly, however, need to understand the financial instruments in which they are involved. One such instrument is the bond.

A Bond is a promise made by a corporate or governmental entity to pay interest to an investor in exchange for the investor’s agreement to loan it money. In the old days, investors received bond certificates with coupons attached that bond holders would present to banks at specified times for interest payments. Coupons are no longer in vogue, nor do investors receive bond certificates, but the term “coupon” lives on in the financial vernacular and is frequently used in lieu of “interest.”

Most people who own bonds know they will receive a principal amount when the bond matures, and they expect to collect interest payments in the interim, but many do not understand how bond prices fluctuate during the life of the bond.

Bonds are offered to the public through an initial public offering (IPO) at a par value, usually $1,000, with a stated coupon rate. From that point forward, the bond is traded in the marketplace, and its value fluctuates with the movement of interest rates, the proximity of the bond’s maturity date, the stability of the issuing entity, and other factors. Thus, buying a bond carries real risk.

All other things remaining equal, the market prices of bonds move inversely to the movement of interest rates. If interest rates go down, bond prices go up. If interest rates go up, bond prices go down. As a bond nears maturity, its market price approaches the par value, and at the end of the term, the investor receives $1,000 and will have earned the agreed-to interest over the life of the bond.

Bond purchasers pay either a discounted price or a premium price with respect to the bond’s par value, depending upon how interest rates have moved since the bond’s issuance. If you buy a bond with a coupon rate of three percent at a time when interest rates have declined to one percent, you will pay a premium for it. If you then hold the bond to maturity, you will earn one percent on your investment because you paid more than par for the bond.

Conversely, if you purchase the same three-percent-coupon bond at a time when interest rates have risen to five percent, the marketplace will discount the price of the bond, making it worth less than its par value, because the three-percent bond is traded in a five-percent-interest-rate environment.

In the early 1980s, the fed funds target interest rate soared to nearly twenty percent and then took almost thirty years to descend to a quarter of a percent today. Many bond holders during that long downward cycle made money as their higher-coupon-rate bonds gained premiums in the marketplace.

The opposite is true now. Those who purchase bonds today run the risk that interest rates will surge and the prices of their bonds will tank. Locking in longer-term interest rates is tempting, but you should carefully weigh the pros and cons before making such decisions. The important thing is to understand the nature of the financial instrument so that you can predict its risks and rewards.

With bonds, as long as the issuing entity remains solvent, you will receive the par amount at maturity. The market price of the bond moves inversely to interest rates, so that if you choose not to hold the bond to term, you will be subject to price swings. Bonds are risky, and you should be careful to characterize them in your portfolio as such.

 
Financial Instruments – A Primer On Bonds ©, by Douglas R. Eikermann

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1 comment… add one

  • Andrea September 13, 2010 at 11:11 am

    Thank you for the great article on bonds.  I’ve always had a hard time understanding them, and the explanation is very clear.  Nowadays it’s hard to know where to put your $ so it doesn’t lose it’s purchasing power over time!

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