by Stephen Vanderpool
Trading bonds may at first seem overwhelming, but, with a little research, the process is not as complicated as you might think. Once you know the basic dynamics of bond trading and its accompanying jargon, you should have no problem getting started.
What are bonds?
When a company or government needs to borrow a large sum of money, they may opt to issue bonds to a public market. Each bond is like a tiny loan. Investors who buy the bonds are essentially lending little chunks of money to the company or government. The borrower agrees to pay back the amount with interest according to a specified timeline.
When people think about investing, their mind often goes directly to the stock market. Before you invest, it is very important to understand the difference between stocks and bonds. Stocks are equity, which makes the purchaser a part-owner of a corporation. Stocks are typically higher risk but yield higher returns. Bonds, on the other hand, are debt. When you purchase a bond, you know exactly how much you should expect to gain. While stocks can be volatile and unpredictable, bonds tend to generate a steady, fixed-income. However, you must always be aware of the possibility of default.
Using bonds to generate income is simple. Once you put down money for a bond, you earn interest on your investment for a specified period of time. Bonds can pay at various intervals, but semi-annually is most common.
To fully understand bonds, you need to learn the lingo. Here is the vital vocabulary for bond-trading hopefuls.
Coupon: Interest rate paid to the bond holder.
Maturity: The date the bond will be redeemed and fully paid off.
Face value / par value / principal: The amount on which interest is paid. The principal is usually repaid in its entirety when the bond reaches maturity.
Price: Prices are listed as a percentage of par (for example, $105.50 equals $1,055.00 per $1,000 bond).
Premium: When a bond trades for more than face value.
Discount: When a bond trades for less than face value.
Yield to Maturity (YTM): The total percentage a bond will yield if held to maturity.
Issuer: The company or government selling the bond.
Bid: What a trader will pay for a bond.
Offer (Ask): How much a trader will sell a bond for.
Bid-offer spread: The difference between how much a trader will pay for a bond and how much the trader will sell the bond for.
Basis points: One basis point is equivalent to 0.01%. For example, a yield that drops from 6% to 5.25% moves 75 basis points.
Spread over governments: The price of non-federal government bonds are often based on comparable government bonds, but some variation does exist. The “spread over governments” is the difference in YTM in basis points between a corporate bond and its government counterpart.
Types of bonds
When deciding where to invest, there are four main types bonds to consider.
Government bonds: Bonds issued by governments tend to be among the safest, especially in stable, developed countries. Securities issued by the US government include Treasury bonds, Treasury notes and Treasury bills. They are entirely tax-free.
Municipal Bonds: Bonds issued by cities (sometimes referred to as “munis”) are also very safe. They are exempt from federal taxes and sometimes exempt from local taxes (though consequentially have a lower yield).
Corporate Bonds: Bonds issued by companies are usually higher risk but higher yield. Two specific types of corporate bonds are: 1) convertible bonds, which can be converted into stock, and 2) callable bonds, which the company can redeem before maturity.
Zero-coupon Bonds: These are bonds that make no interest payments until maturity, but are issued at a substantial discount. For example, you might buy a bond with a $2,000 par value for $1,200. When the bond reaches maturity, you’re up $800.
When deciding on which bonds to invest in, there are a number of factors to consider. First, assess your personal needs. If you’re looking to simply maximize capital gains, you may want to buy long-term bonds when interest rates are high. If you’re looking for a steady source of income, short- to medium-term bonds may be the right pick.
Obviously, you want both a high yield and, more importantly, a high total return to make the most of your investment. But be careful. High yield is often indicative of high risk. Check the issuer’s bond rating before making an investment. Ratings range from AAA at the high end to D at the low end. The lower the rating, the riskier the investment. When an issuer’s credit rating falls below a certain score, its bonds are considered “junk bonds” and point to financial strife within the company. While bonds are generally seen as a safe investment, junk bonds can be riskier than purchasing stock.
You should also diversify your portfolio. Bonds may be a relatively safe investment, but they shouldn’t be your only investment. Because they provide a steady income, bonds are often recommended for older investors nearing retirement.
Where to buy
When you’re ready to look at bonds, you have a few options. You can purchase directly through the government, through a financial institution or through a bond broker. If you use a broker, expect them to charge commission. If a broker claims not to be charging commission, be skeptical. Sometimes they will bump up the price of your purchase, which is really a surreptitious way of charging commission. Look up the most recent quote for the bond to make sure the markup isn’t a complete rip-off.
One final piece of advice: Do your homework! The more time and research you pour into your investments, the smarter your choices will be. This article provides a basic overview of and introduction into the world of bonds, but it’s only the beginning. Making wise investments is a simple matter of getting informed.