Basics of Investing with Bonds
Overview

What is a Bond?

Another way in which entities can raise capital to fund its operations is through the issuance of bonds, or debt securities. A bond is a promise by a borrower to repay the principal plus a pre-determined rate of interest to the bondholder within a specified period of time. The amount of time until the bond comes due, or its maturity date, can range from one year or longer. While most bonds mature within 30 years of issuance, bonds with much longer maturities do exist. In 1993, the Walt Disney Company issued “Sleeping Beauty” bonds with a term of 100 years. In theory, the longer the time to maturity the higher the interest rate.

Consider your own home mortgage. When you applied for your mortgage, you were likely quoted an interest rate for a 15-year mortgage and for a 30-year mortgage. Which had the higher interest rate associated with it? Bonds work in a similar fashion in most cases. There are times, however, when this doesn’t hold true – particularly for government bonds. We will talk about inverted yield curves at a later date.

The Inverse Relationship Between Bond Prices and Interest Rates

When you invest in a bond, your investment return is dependent upon 1) Price appreciation and 2) Interest payments. Bonds can be purchased on the primary market directly from the issuer (i.e. U.S. Treasury) or on the secondary market from other investors. The original issuer’s obligations under each bond, such as interest rate and term-to-maturity, are set forth in the bond’s covenants when the bond is originally issued and do not change for the original issuer.

On the secondary market (bond market), however, the price of the bond and its interest rate fluctuates based upon supply/demand and the outlook for economic activity (Treasury securities) or for a particular company’s operations (corporate bonds). The relationship between a bond’s price and its interest rate is inversely related. This means that as interest rates increase, the price of a bond will decline and as interest rates decrease the price of a bond will increase.

Before we go on, let’s discuss some key bond terminology:

  • Face Value is simply the amount of money that you will receive when the bond matures in the future. In the example below, this amount is $1,000.
  • Term-to-Maturity is the amount of time until the bond must be repaid by the borrower. In the example below, this is 10 years.
  • Coupon rate is the interest rate that the borrower agrees to pay when it first issued the bond. Regardless of what happens to market interest rates after the bond is sold to investors, the original issuer will be required to pay no more, or no less, than what is set forth in the bond covenant. In the example below this is a total of $100/year.

Now, let’s walk through an example. Assume that in January 2011, the U.S. treasury issued a series of 10-year bonds. The bonds will carry a coupon rate of 10% and will mature in January 2021. Primary market investors, typically mutual funds, hedge funds and foreign governments, will pay the Treasury $1,000 for each bond purchased. In exchange, the Treasury will be required to pay the investor a coupon payment of $100 (typically two semi-annual payments of $50) each year until January 2021 when the bond matures. In January 2021, the investor will receive his or her final interest payment, as well as the initial amount invested ($1,000). This example assumes that the initial investors hold onto the bond for the entire 10 years; however, this rarely is the case. Many investors will sell their bonds on the secondary market before January 2021.

So, let’s assume that in January 2012, the Treasury will issue more bonds; however, during 2011 market interest rates rose to 12%. In order to make its bonds competitive with other bonds being issued, the Treasury will have to issue these bonds with a coupon rate of 12% and pay total interest payments of $120 per year on these new bonds. Remember, however, that the bonds that the Treasury issued in January 2011 are only paying $100 per year in coupon payments. As a result, those investors who own the 2011 bonds will have to lower their asking price from $1,000 to approximately $833 if those investors wish to sell those bonds on the secondary market. Otherwise, new investors will simply purchase the new, 2012 bonds from the Treasury.

So, in this case, as market interest rates went up, the price of previously issued bonds trading on the secondary market went down. While many factors influence market interest rates, the macroeconomic environment and the Federal Reserve are typically the most powerful influencers of interest rates.

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