WASHINGTON, July 3, 2016 – In our last episode, we began to explore the wonderful world of bonds. Understood in a general way as debt instruments, bonds are essentially loans to companies and institutions as opposed to common stocks, shares of which represent ownership in companies and institutions.
Maybe the easiest way to understand a bond is to compare a bond investment to your mortgage or car loan. When we buy a house, we sign a never-ending mass of documents and agreements until the party across the table tells us to stop and asks us for our certified down payment check. At that point, both parties have a valid contract, and we walk away owning our new home.
But not really. As homeowners often joke, it’s the bank that owns the house, not them. Which is actually the truth. The new homeowner is now indebted to the bank and must pay that loan back at an agreed rate of interest and over an agreed-upon period of time. The homeowner is indebted to the bank. The bank owns the homeowner’s debt—a debt that must be repaid over time as per the agreement.
In other words, the bank has loaned us the money, and now owns a debt instrument (mortgage) that requires the homeowner to pay the money (principal) back at given intervals (usually monthly) with interest.
A bond is pretty much the same thing, except that we—the ones who usually owe debt to banks—are in this case the debt holders. We hold a piece of a large company’s debt, which the company must pay back to us over time, with interest.
Unlike a mortgage or a car payment, however, a bondholder generally gets interest payments only over the life of a bond. The principal all comes back at the end of the bond’s life or holding period, which can be as long as 30 years or more.
In real life, banks often buy or sell mortgages they’ve originated, sometimes in complex deals like the packaged mortgage-backed securities (MBS) that, alas, initiated the Great Recession. Why did that happen? Simple. It’s because once a bond—or a packages or “tranche” of mortgage loans packaged like a bond—is newly issued to new holders, it is available for trading on the open market. And on the open market, each debt instrument fluctuates every day in terms of value.
For our purposes, let’s forget about those MBSs and their brothers and sisters and just focus on corporate and municipal bonds, the kind of investments we little guys can actually afford, more or less.
How do bonds actually work?
In this section, we’ll take a look at how bonds actually function on the market. All info here applies to both corporate bonds, aka “corporates” and municipal bonds, aka “municipals” or “munis.” (The distinction between the two is examined in our previous installment.)
In the marketplace, a bond functions similar to the way preferred stocks function, something we noted in our previous installment on preferreds. When a bond first comes to market, it’s priced at “par,” just like a preferred stock. Unlike most preferreds, however, the usual “par value” of a bond is $1,000 per bond.
The par value of a bond, although it’s nearly always $1,000, is important, because that’s the number upon which the rate of interest the bond pays is determined. In other words, if you’re buying one $1,000 bond that pays you an annual interest rate of, say, 5 percent, this means the bond will pay you $50 of interest every year until it matures. (More on this in just a moment.) In other words, 5 percent, or .05 x $1000 = $50.
In the world of bonds, your interest is usually paid out to you in two installments per year, or semi-annually. In this case, that’s $25 x 2 = $50. So if your bond pays out $25 in January, it will pay out another $25 in July. Payout months will vary according to issue, but the intervals involved are (almost) always 6 months apart, at least in my experience. Clever bond buyers primarily looking for regular income will put together bond portfolios that effectively pay out every month. For example, Bond A will pay out January and July, Bond B will pay out in February and August, Bond C will pay out in March and September… you get the picture.
Now let’s make things a little more complicated since we’re living in the real world. Once that new $1,000 bond issue has been sold to its initial owners, it, like a common stock, is available to trade on the open market. From that day forward, the value of that bond on the open market will fluctuate constantly, based on the current going rate of interest.
This brings us to our key rule of thumb, which also pertains to preferred stocks as well as to common stocks that serve as bond analogues, such as utility stocks, real estate investment trusts (REITS) and others. (We’ll explore these a bit later when we drill down on specific stock market groups or sectors.)
Here’s that simple rule: When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. This simple rule almost always holds true, save in times of extreme economic stress, as horrified bond holders learned very quickly when they saw the value of their bond holdings drop like Wile E. Coyote during the Great Recession. Nearly all the time, however, our basic rule holds true, as we learned during last week’s “Brexit” escapade when interest rates dropped quickly as bond prices rose, sometimes to record levels.
What is always certain, however, is that between its original issue date and its maturity date, the price of your bond will be worth more or less than what you paid for it. That’s because bond pricing every day adjusts around its fixed interest rate. If you can buy a newly issued bond today carrying a higher interest rate than your bond pays, the market price for your bond will go down to the point where the math works out to give a new purchaser of your bond today’s equivalent interest rate.
In other words, on a theoretical plane at least, new and old bonds alike tend to trade on any given day to provide a new buyer with the prevailing current yield pushing the price of each bonds up or down depending on where things happen to be going.
The actual amount of interest paid on each bond is the same as the original, agreed-upon dollar amount. But the value of the bond will fluctuate up or down on any given trading day depending on whether that bond is offering a lower or higher rate of return compared to any brand new bond of equivalent quality that an investor can purchase new today.
Some oversimplified bond math
Remember that your conjectural bond above was issued with an annual interest rate payout of 5 percent, which equals 0.05, which equals $50 interest per annum. If a brand new bond from a different company is being sold today paying interest of 5.5 percent, that reality will cause the price of your existing bond to drop on the open market. By how much? All factors being equal (again, more later), here’s how you’d figure it:
Since your bond pays an annual dividend of $50 and the new one pays $55 ($1,000 x 5.5 percent), you start out by dividing 50 by 55 which gives you (in round figures) .90909.
Multiplying $1,000 by .90909 gives you a total of $909.09—the new value of your bond today on the open market. Need proof? Remember that your bond pays $50 of interest. So put 50 over 10000 and divide, i.e., 50 divided by 1000. What you get is 0.055 or 5.5 percent. So by buying your lower interest rate bond today for the price of $909.09, your buyer will be getting the equivalent return of a new bond being sold today for that higher interest rate.
Yeah, it’s a little confusing. But it basically means that each day’s prevailing interest rate determines the price that older, already existing bonds will be bought and sold for.
This brings us to several important terms. A bond selling lower than par value ($1,000) is selling for a discount. It’s a discount bond. If the reverse situation holds true, if interest rates have gone down, making your existing bond more valuable on the market because it’s paying a higher rate of interest than a new one, it will trade higher than par value ($1,000). It’s now selling for a premium. It’s a premium bond.
This situation will continue until your bond matures, a term we mentioned we’d eventually get to. That’s because most bonds come with an expiration date, just like the term preferred stocks we discussed in a previous episode. The expiration date is the date the bond matures. On that date, bondholders like you and me will get their final interest installment. In addition, they’ll get all the original principal back, i.e., par value, i.e., $1,000. That’s true no matter what the investor actually paid to buy the bond in the first place.
Suffice it to say at this point that, as you’re probably already beginning to see, bonds are favored investments individuals primarily looking for regular income or an income substitute. Not surprisingly, we’re mostly talking about individuals nearing retirement or already retired. They don’t much mind a bond’s fluctuation in principal over its lifetime because they don’t intend to trade it anyway. They just want to hold it and collect the interest. These investors are mainly concerned with getting a regular, stable income, and capital gains aren’t their game.
Older investors tend to be heavily into bonds for this reason, while younger investors don’t find them too appealing. Younger investors like dividends and interest, too. But, needing to make their pile grow as fast as possible, they’re more interested in handsome capital gains, which, however, are riskier. Old timers are simply more interested in maintaining the capital they’ve already put away and become more and more risk-averse with age. We only live so long. Hence the differentiation.
Quaint but useful bond terms
As we’ve noted, a bond is a debt instrument that pays you interest, not dividends, and the interest is paid out to you semi-annually (2x per year) at a fixed rate, just like most preferred stocks.
Back in the day, people actually took delivery of physical bonds, most of which actually had pages of little coupons attached, something like the coupons you see in newspaper grocery ads or online promos. Twice a year, bondholders would take a scissors, clip the next coupon and take it to a broker or a bank, which would then pay out the interest on the bond. That’s why those bonds were known as coupon bonds.
Today, most if not all bonds are sold and traded as “book entry.” In other words, computers keep track of this stuff now. You never see a physical bond any more. But their virtual coupons pay off twice a year just like old times, except that your interest now just shows up in your account at the appropriate time.
To this day, however, you’ll hear investment veterans using the term “coupon.” As in, “this 3M bond has a 5 percent coupon.”
The original fixed interest rate on a new bond—the amount of interest payout that will never vary—is thus sometimes called the “coupon” or “yield.” Once that bond is out on the market fluctuating in price, the relative value of that coupon will vary depending on the price you pay for the bond. So the “rolling interest rate” on that traded bond is known as the “current yield” to distinguish it from the original coupon rate.
By cranking a bit more math (we may offer the formula later, but not here for the sake of current clarity), we can establish a third figure known as the “yield to maturity.” That factors in the current yield and combines it with the gain or loss you might get when you’re bond is called (definition later) or reaches maturity.
For my purposes, I generally try to buy discount bonds on the open market. That’s so that at some time in the future, I’ll get the full face amount ($1,000 x number of bonds purchased) from the issuer upon the bond’s redemption while enjoying all the generally predictable interest payments in the mean time.
I can see eyes glazing over out there. So let’s end this chapter on bonds right here and pick up next time on the rest of the mechanics, by which we mean the assessment of bond quality via rating systems. Not all corporate and muni bonds are created equal and some are riskier than others. That’s why we have ratings agencies and systems to let us know about all this. We’ll explore their importance (and occasional failures) in our more or less final installment on bonds.
Next: S&P, Moodys and Fitch: The big three firms that rate bonds and how these ratings can affect interest, yield, price—and reflect risk.