With all the commentary about the economy and the impact of inflation, I thought it would be a good time to look at some investing basics. My passion for investing has always been throttled by a very conservative nature. Therefore, I have always been attracted to buying bonds.
What are bonds?
Basically, in its simplest form, a bond is an “I owe you” issued by a company, agency, or governmental body. It is a legal contract used by an organization to borrow money. The funds are usually put to work as operating capital, i.e., used to buy inventory, expand manufacturing, build a bridge or even a football stadium.
Bonds come in a variety of types: corporate, agency, savings, municipal (usually these are tax free), and treasury bonds.
Bonds are issued with a stated rate of interest that they pay over the life of the bond contract. This is the reward an investor receives for in effect making a loan to the issuer. The bonds also have a face value which is the amount the purchaser will be paid when the bond matures. This amount is usually $1,000 per individual bond.
Finally, the bond has a specified term, usually 1 year to 30 years. The date a bond becomes due is called the maturity date. Some bonds have a “callable” provision which just means that the issuer can redeem them prior to their stated maturity date.
How do you buy a bond?
Bonds can be bought from the original issuer or on the secondary market. These individual bonds allow the investor to pick the specific term and interest rate. This can allow a buyer to “ladder” the bonds by maturity date in order to create a fixed stream of interest payments.
Additionally, bonds can be purchased in a bond fund that owns multiple individual issues. These funds tend to employ different strategies based on their investment goals. A benefit of a bond fund is that it helps to lower risk by adding diversification to a bond portfolio.
What is a Premium or Discount?
The price that a buyer pays for a bond is based on several factors: the face amount, the credit quality of the issuer, the stated rate of interest the bond pays, and the current market rate of interest.
If a Bond’s stated rate of interest is more than the market rate, it will sell at a premium. For example, a $1,000 bond paying 8% interest today might cost $1,100, a 10% premium.
The reverse is true concerning a discount. If a $1,000 bond was paying 1% in today’s higher interest rate environment, it might sell for a 6% discount at $940.
Do bonds get a grade?
Here is an area my students are very keen on! Bonds do get a grade, but it is earned in a very different fashion. Bond grades are assigned based on the credit quality of the issuer. In layman’s terms, how well can the organization pay back its debt.
The grading system generally ranges from AAA all the way down to D. The higher grades are given to what the industry terms “Investment Grade” bonds, which are BBB- and higher scored bonds.
Bonds that don’t qualify as investment grade, BB+ and lower, are labeled as “junk bonds”. Junk can be a deceptive term as there are some very good bonds found in this category. The benefit is that they usually pay a much higher interest rate to entice an investor to buy them. This might be a very good area to consider a bond fund for these types of investments.
What about the impact of inflation?
Inflation is real! We all are feeling the recent impact on our pocketbooks. The federal reserve has even raised the central funds rate six times in 2022 for a year to date increase of 3.75% to try and curb inflation.
Many investors tend to shy away from bonds in periods of rising interest rates. It is true that rising rates can lower the price of bonds in the market, making their overall valuations decline. While this may be intimidating, it can also be a very good investing opportunity as the bonds are basically going on sale.
During these periods of increasing rates, the discounts on bonds (outlined above) tend to increase. So, a bond that may of cost $1,000 at issuance can now be purchased for say $950 (a 5% discount). The theory behind this is that the bond price has to drop so that the amount of interest it pays to an investor effectively goes up to match the increased market rate.
Any Sage advice?
The so called “sage advice” I was given as young investor is to buy bonds not bond funds. I have taken this to heart, and while I do own some bond funds, the vast majority of my bond purchases are individual bond issues.
The secret behind this bond buying strategy is simple. Buy and hold an individual bond to maturity and you will not have to be concerned with the constant market fluctuations. This holds true because when a bond matures, the investor is paid the face value of the bond regardless of the market price.
In expanding on this strategy, the bonds one purchases at a discount deliver their gains at maturity. For example, that bond acquired above at $950 will mature at face value and pay $1,000, a gain of $50.
Bond funds on the other hand, are always purchased and sold at the market price. So, rising interest rates due to inflation can drive down the fund’s price and create a loss if an investor sells them at the wrong time.
While there are risks with any investment, including bonds, the rewards can be worth it. I always recommend that you consider using the services of a professional when making investments choices. An added benefit is that a professional bond buyer generally has access to a larger inventory of bonds to select from.
So, put that cash to work and let it bring home a paycheck to help in these inflationary times!
To learn more about the various business degrees offered at the West Texas A & M University Paul and Virginia Engler College of Business, click here.
David W Clark, MPA, CPA