Bonds play a key role in a well-balanced portfolio, but so far here at Dynalect we haven’t spent much time talking about how to invest in bonds or what to look for in the bond market. As a young investor, bonds can be an excellent way to set aside money for the long term and receive “coupon” payments periodically. Especially as equities valuations are soaring in the US and many finance professionals are warning of an eminent correction or economic downturn, this is a great time to introduce the bond market to Dynalect readers and to offer yet another compelling investment opportunity to help you build your portfolio and curb some of the risk you might hold in your equity assets.
Over the next several weeks, sprinkled in alongside the cryptocurrency investigation, I will be offering a series of bond related posts that dive into the particulars of interest rates, emerging market bonds, and plenty more that will be relevant to you and your developing portfolio. For this week, let’s start with the basics and explore what a bond is and how you can get involved in the bond market.
First, there are many different types of bonds, which all offer their own unique features and opportunities to investors, but at the end of the day all bonds are just IOUs from the issuing entity. Whether or not you are buying corporate or government bonds, single coupon or zero-coupon bonds, long-term or short-term bonds, emerging market or stable bonds: when you purchase a bond you are loaning money to an organization and expecting to be paid back at a later date according to the terms of the bond contract.
One of the most common distinctions between bonds falls along the lines of the public and private sector. Corporate bonds are issued by private corporations that are interested in raising money by issuing debt. Government bonds can be issued and guaranteed by all levels of government; in the United States bonds are issued not only by the Federal Reserve, but also by states and municipalities in order to borrow money to finance public projects.
Bonds are also characterized by the maturity time of the asset, which means the amount of time that your particular investment will take to reach its “face” or nominal value. For example, if you purchase a $1,000 bond for $950 at a 10-year maturity, your bond will be worth $1,000 after 10 years. Technically, in the United States, a security is only classified as a “bond” if the maturity of the asset is greater than 10 years; anything less than 10 years is a “bill” (less than 1 year maturity) or a “note” (between 1 and 10 year maturity).
Finally, a bond “coupon” is an interest payment you receive before the maturity of a bond. Coupon bonds are described by several components: 1. the par value, 2, the coupon rate, 3. time to maturity, and 4. the coupon payment schedule. The par value is the face value of the bond at maturity. When a bond pays a coupon, the value of the coupon will be measured by a coupon rate, which is applied to the par value to compute the size of the coupon. So let’s say that you buy a bond that has a par-value of $1,000, a coupon rate of 10%, a maturity of 10 years, and a semi-annual coupon payment schedule. Every six months, you will receive $50 from the bond ($1,000 x 10% / 2). If you bought the bond for only $850, your annual yield would be 11.76% ($100/$850).
Bonds that do not pay coupons are called zero-coupon bonds or “z-bonds.” Z-bonds generally trade at lower prices relative to their face value because they appreciate more as they mature; for example, a $1,000 z-bond with a 20-year maturity might trade for $600, but not yield any payments throughout the 20 years until the security is ultimately worth $1,000 at maturity.
Government bonds issued by the United States are considered to carry essentially zero-risk, and serve as an attractive safe haven for investors who are worried about the prospects of global equities markets in the short term. Other bonds issued by developing countries such as South Africa are considered to be “junk,” and therefore pay a much higher interest rate; thus can be viewed as a more lucrative investment opportunity, but also carry far more risk. The bond market is extremely diverse, and there are a many different factors to consider when choosing the right security!
So how can you get involved in trading bonds?
That’s it for this week. Stay tuned to read more about bonds in upcoming articles!
Until next time…