Bonds — Lending Money for Interest

Why It Matters

Most people under 30 have never consciously bought a bond and could not explain what one is. This is strange, because bonds make up a significant portion of the global financial system. Governments fund themselves with bonds. Companies fund expansion with bonds. Retirement portfolios often hold large amounts of bonds. Understanding them is basic financial literacy.

Learning what bonds are lets you round out your picture of investing. Stocks alone are volatile — their prices swing a lot, and for some portfolios (especially those close to retirement) that volatility is a problem. Bonds are less volatile, pay steady interest, and tend to hold value even when stocks are crashing. A mix of stocks and bonds is the classic diversified portfolio for a reason.

This lesson also teaches you to see the debt side of the investing world. Until now, every investment discussed has been about ownership — owning a piece of a company, a property, an asset. Bonds are the other side: you are the lender, and someone else owes you money. Both sides of this relationship exist in every economy, and both can produce real returns for patient participants.

Finally, understanding bonds helps you understand interest rates, which in turn helps you understand most macroeconomic news. When you hear about the Federal Reserve raising or lowering rates, or about bond yields moving, or about the national debt — all of this is rooted in the bond market. Bonds are the connective tissue of modern finance.

A Story

The Town That Needed a Library

Imagine a small town that needed to build a new library. The library would cost $2 million. The town did not have $2 million in its savings, but it did have steady tax revenue coming in over time. How could it build the library now and pay for it later?

The answer most real towns use: they issue a bond. Specifically, a municipal bond. The town goes to the bond market and offers to borrow $2 million from investors. It promises to pay those investors a specific interest rate — say, 4 percent per year — and to return the full $2 million at a specific maturity date, say, 20 years from now.

An investor named Eloise, who has some savings and wants a steady, low-risk return, decides to buy $10,000 worth of the town’s bonds. In return, she will receive $400 per year (4 percent of $10,000) for the next 20 years, and at the end, she will get her $10,000 back.

Over 20 years, Eloise receives $8,000 in interest payments ($400 per year times 20 years) plus her original $10,000 back. She has turned $10,000 into $18,000, steadily, with almost no risk, as long as the town can meet its obligations — which towns usually can.

Meanwhile, the town got its $2 million right away and built the library. It pays back the bondholders slowly through tax revenue. Everyone got what they wanted. The investor got a steady return. The town got its library.

Now change the scenario slightly. Instead of a stable town, imagine the bond is issued by a new company that wants to build a factory. The company is promising 7 percent interest instead of 4 percent — higher because the risk is higher. If the company fails, the bondholders might not get their interest payments or even their principal back. In exchange for taking on that risk, investors are paid more. This is how bond interest rates work: more risk means higher interest, less risk means lower interest.

The US government also issues bonds — Treasury bonds, Treasury notes, Treasury bills — to fund the government’s operations. These are considered among the safest investments in the world because the US government has always paid its bonds back (the government can, in the last resort, print the money it needs). US Treasury bonds often pay the lowest interest rates because they are the lowest risk. Higher-risk borrowers — troubled companies, emerging market countries, speculative projects — have to pay higher rates to attract lenders.

This is the shape of the entire bond market: different borrowers at different risk levels, each paying interest appropriate to their risk, borrowing money from investors who want steady income. Trillions of dollars flow through this system every year. Most of it is invisible to ordinary people, but it funds much of the world’s economy.

Vocabulary

Bond

A loan from an investor to a borrower (company, government, organization), repaid with interest over a specific period. The borrower agrees to pay interest at regular intervals and return the principal at maturity.

Principal (bond)

The original amount you lent when you bought the bond. Also called the face value. Returned to you at maturity if the borrower honors the bond.

Coupon rate

The interest rate the bond pays, expressed as a percentage of the principal per year. A $1,000 bond with a 5 percent coupon pays $50 per year.

Maturity

The date when the bond is supposed to be paid back in full. Bonds can have maturities of a few months (Treasury bills), a few years (Treasury notes), or decades (long-term bonds).

Default

When a borrower fails to make its bond payments. Default is the main risk of bonds, and bonds with higher default risk pay higher interest to compensate.

Guided Teaching

Let’s walk through the mechanics of a bond in careful detail, because they are simpler than people think.

When you buy a bond, you are making a loan. The borrower is the issuer (a government, a corporation, a municipality). The lender is you. The bond document specifies everything: how much you lent, what interest rate they will pay, when they will pay it, and when they will return your principal.

Ask: if you lent $1,000 to a friend for five years at 5 percent simple interest, how much would they pay you in interest each year, and how much total would you receive at the end?

Answer: $50 per year, so $250 total interest, plus the original $1,000 back at the end, for a total of $1,250. That is the basic math of a simple bond.

Real bonds vary in the details, but the shape is the same. You give money. You receive interest payments (usually semi-annually). You get your principal back at maturity. The two main questions with any bond are: will the issuer actually pay as promised, and is the interest rate high enough to compensate for the risk and for the time you are tying up your money?

Bond risk comes in several flavors. Credit risk is the chance the issuer defaults. US Treasury bonds have almost no credit risk. Investment-grade corporate bonds have low credit risk. High-yield (or junk) bonds have higher credit risk and pay more interest to compensate. Interest rate risk is the chance that market interest rates rise after you buy a bond, making your fixed-rate bond less attractive compared to newer bonds at higher rates. Inflation risk is the chance that inflation eats away the real value of your fixed payments. All three matter, and each is priced into the bond’s yield.

Bonds versus stocks. Stocks give you ownership — you share in the company’s profits and growth, but also its losses. Bonds give you a claim — you are owed a specific amount regardless of whether the company does well or poorly, as long as they can pay. If the company goes bankrupt, bondholders get paid before stockholders. That seniority is the main reason bonds are less risky than stocks: you are higher in line.

For most long-term investors, bonds play a specific role: stability. Stocks grow more over long periods but can crash hard. Bonds grow less but hold value better during crashes. A mix of the two is more stable than either alone. A common rule of thumb is to hold more bonds as you get closer to retirement, because you have less time to recover from a stock market crash and need the steadier returns.

One more thing. Bonds can be bought individually or through bond funds, which are baskets of many bonds bundled together. For most individual investors, bond funds are simpler and more diversified than picking individual bonds. Your retirement account probably holds bond funds already, even if you have never looked at the details.

For Discussion

1. 1.In your own words, what is a bond?
2. 2.In the library example, what did the town get and what did Eloise get?
3. 3.What is the difference between credit risk, interest rate risk, and inflation risk?
4. 4.Why is a US Treasury bond considered one of the safest investments?
5. 5.What is the difference between a stock and a bond in terms of what you actually own?
6. 6.Why might a portfolio include both stocks and bonds?
7. 7.What is the difference between an individual bond and a bond fund?

Practice

The Bond Calculation

1. 1.Imagine you buy a $5,000 bond with a 4 percent coupon and a 10-year maturity.
2. 2.Calculate how much interest you receive each year, and how much total interest over the life of the bond.
3. 3.Calculate the total amount you will receive — interest plus principal — over the 10 years.
4. 4.Compare that total to what $5,000 might grow to in a stock market index fund averaging 7 percent over the same 10 years (use the formula $5000 × (1.07)^10).
5. 5.Share with a parent and discuss when each approach might be appropriate.

Memory Questions

1. 1.What is a bond, in your own words?
2. 2.What is the principal? What is the coupon rate?
3. 3.What is default, and what is credit risk?
4. 4.How are bonds different from stocks in terms of what you own?
5. 5.Why do US Treasury bonds usually pay low interest?
6. 6.Why might a portfolio include bonds even if they have lower long-term returns than stocks?