How Bonds Work

When you purchase a bond, you are lending money to the government, a municipality, corporation, federal agency or other entity known as an issuer. In return for that money, the issuer promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.

Let’s say you purchase (i.e., lend) $1,000 for 10 years in return for a yearly payment of 3.75% interest. The $1,000 of principal is the bond’s face value, the yearly interest payment is its coupon, and the length of the loan is its maturity.

Bond Pricing and Yield

The price of bonds moves in the opposite direction of interest rates. When interest rates rise, bond prices fall; when interest rates fall, bond prices rise. This is because the interest you are earning on a bond is fixed. For example, let’s say you purchase $1,000 worth of new 10-year bonds with a coupon of 3.75% at par (100). Your total return for the investment will be 3.75% (you are getting back your $1,000 upon maturity, and collecting $375 per year in income).

Now suppose you hold the bond for one year, during which time interest rates on bonds have increased to 4.75%. Because the coupon on your bond is fixed at 3.75%, no one would be willing to purchase the bond from you at 100, because the 3.75% coupon is less than the 4.75% bonds they could buy today. Your bond is now worth 92.75, or $927.50.

Similarly, if interest rates fall to 2.75%, your bond will be worth 107.75, or $1,077.50. Notice that for every 1% change in the interest rate, the price moves either up or down by 7.5%.

This measure of a bond’s price sensitivity to changes in interest rates is called duration. Although a bond’s price may fluctuate while it’s in your portfolio, it will eventually come back to par (100) upon maturity, and you will get your original $1000 investment back.

Unless bonds are new issues, they rarely sell for exactly face value or par. Take a $1,000 bond with a 4% coupon that matures in the year 2014. If you manage to buy it for $800, you’ve effectively bought a bond with a 5% coupon, since the $40 coupon is 5% of your $800 purchase price. The current yield of the bond is 5% (the coupon rate adjusted for the current bond price). Better yet, even though you paid $800, in 2014 you will receive the full $1,000 face value. The total return, taking into account the $200 capital gain, is called the yield to maturity.

Bond Maturity

A bond’s maturity refers to the specific future date on which an investor’s principal will be repaid. Generally, bond terms range from one year to 30 years. Shorter-term bonds, which generally offer lower returns, are considered comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term bonds provide greater overall returns to compensate investors for greater pricing fluctuations and other market risks.

This relationship can best be demonstrated by drawing a line between the yields available on similar bonds of different maturities, from shortest to longest. This yield curve can indicate the direction interest rates may be heading, which is an important factor that could affect the price of bonds.

To learn more about how the yield curve works, go to SmartMoney.com’s Living Yield Curve.

Bond Risk

Although bonds are considered less risky than stocks, they are not risk free. Some of their risks include:

Market Price Risk (or Interest Rate Risk)

The longer a bond’s maturity, the higher the duration. That is, the price of a 30-year bond will fluctuate more than that of a 10-year bond. This potential price volatility is referred to as market price risk. Because longer-term bonds pay higher yields, many investors purchase them without being fully aware of the risks. If interest rates rise, investors who sell their bonds before they mature will likely lose some of their principal.

A 30-year bond has a duration of about 16 years, meaning that the bond’s price will drop 16% for every 1% increase in interest rates. Market price risk can be eliminated by holding bonds to full maturity so that you get back the face value of the bond. Interest rate risk can be minimized by building a bond ladder in which some bonds mature each year so that money can be reinvested at higher coupon rates.

Call Risk

Your loan may be paid back early, or called; this forces you to find another, possibly less lucrative, place to put your money. A call provision offers protection to the issuer; consequently,callable bonds usually offer a higher annual return than comparable non-callable bonds to compensate the investor for the risk that the proceeds of a called bond will have to be reinvested at a lower interest rate.

Default Risk (or Credit Risk)

Occasionally companies and state and local governments default on their loans or go bankrupt (U.S. Treasury bonds are considered risk free). Default risk can never be completely eliminated, but it is rare for high quality bonds (grade Aa/AA or better) to default; furthermore, some bonds can be insured. Diversification among types of bonds, corporate sectors, and geographic locations will help to minimize such risk.

Liquidity Risk

If the bond issuer’s credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer.

It is important to realize that bonds can and do decline in value. Historically, however, they show much less volatility than stocks do. This is demonstrated in the following table:

Name

Ticker

Inception Date

Worst 1 Year Return

10 Yr Avg. Return(as of 3/31/12)

Vanguard Total Bond Market Index

VBMFX

1986

-00.76 in 1999

5.51%

Vanguard Total Stock Market Index

VTSMX

1992

-37.04 in 2008

4.92%

Bond Ratings

Bonds are rated for their credit quality by evaluating the bond issuer’s financial strength. There are primarily three services that rate bonds of all types: Standard & Poor’s, Moody’s, and Fitch. Bond ratings are expressed as letters ranging from AAA, which is the highest grade (lowest risk), to C, which is the lowest grade (highest risk).

All three services use the same letter grades, but each one uses different combinations of upper- and lower-case letters. Bonds from AAA to BBB are considered investment grade. Grade C bonds are also known as junk bonds. Grade D bonds are in default; this means they have either not been making coupon payments or they have filed for bankruptcy.

Bond Rating Grades

Credit Risk Moody’s Standard and Poor’s Fitch Ratings
Investment Grade
  Highest Quality  Aaa  AAA  AAA
  High Quality  Aa  AA  AA
  Upper Medium  A  A  A
  Medium  Baa  BBB  BBB
Not Investment Grade
  Lower Medium  Ba  BB  BB
  Lower Grade  B  B  B
  Poor Grade  Caa  CCC  CCC
  Speculative  Ca  CC  CC
  No Payments / Bankruptcy  C  D  C
In Default  C  D  D

Bond Defaults

Historically, defaults on investment grade bonds are rare for both municipal and corporate bonds. The chart below shows the default rates of municipal bonds compared to corporate bonds over the time period 1970-2008. As you can see, portfolios consisting of Aaa/AAA and Aa/AA bonds have a very low probability of default.

Bond Default Rates—Cumulative Percent (1970–2008)

 Chart of Bond Default Rates

Taxes

Some bonds offer special tax advantages. For example, interest from U.S. Treasury bonds is not subject to state or local income tax. Many municipal bonds are triple tax-free; that is, for investors who live in the same state as the issuer, the interest received from the bond may be exempt from federal, state and/or local income tax. The choice between taxable and tax-exempt bond income depends on one’s income tax bracket as well as on the difference between what can be earned from taxable versus tax-exempt bonds.