Understanding Bonds & How They Work

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What Is a Bond?

Welcome back to Pave Academy. Today, we will talk about another crucial asset class in the world of finance—Bonds.

So, what exactly is a bond? Simply put, a bond is a loan. But instead of going to a bank to borrow money, companies or governments will issue bonds to raise capital. Instead of asking for capital to invest in the company and enjoy a share of the profits, companies approach investors as borrowers to ask them to lend the company money. Bondholders get paid back at the end of the loan term when the bond matures. In the interim, bondholders are paid a regular amount of interest or coupon income from that bond. It is similar to a dividend payment but is often a fixed sum agreed upon at the bond issuance. When you purchase a bond, you essentially lend money to the issuer for a defined period and at a fixed or variable interest rate.

You might wonder, "Why do companies bother to issue bonds?" Bonds are issued for many of the same reasons companies issue stocks: to raise money for various projects or activities. However, unlike stocks, bonds come with a promise to pay back the borrowed amount, known as the principal, in addition to interest payments over a set period, often semi-annually.

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Bond Terms You Should Know

Before you venture into bond investing, there's a glossary of key terms you'll need to understand to make informed decisions.

The "face value," also known as the" par value," is a crucial concept. This concept is the amount of money you, the investor, will receive from the issuer when the bond reaches its maturity date. It's the initial amount of the bond and the amount of money you pay for it if you purchase it on the date the bond is issued.  It serves as the standard upon which other bond calculations are made. Notably, the face value is set when the bond is issued and stays the same over time, regardless of market conditions. If you purchase the bond from someone else after issuance, the purchase price will likely be different than par, based on how market conditions have changed since the issuance date. The amount you receive at maturity always stays the same, however.

Next is the "coupon," which is essentially the interest rate the bond pays out over its lifespan. The term originates from older physical bonds, which came with coupons you'd clip and redeem for interest payments. Today, this is primarily digital, but the concept remains. The coupon rate is a percentage of the bond’s face value and dictates your periodic interest payments. These payments are usually made semi-annually, though the frequency can vary depending on the bond terms.

Lastly, the "maturity date" is another key term that refers to the date when the issuer has agreed to repay the face value of the bond. This date is essentially the finish line for the bond's lifecycle. Bonds can have varying lengths until maturity, ranging from short-term (less than two years) to medium-term (two to ten years) and long-term (more than ten years). The maturity date is crucial for planning your investment horizon. Upon maturity, the issuer must pay back the face value to the bondholders, and the contractual obligations are considered fulfilled.

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What Are the Risks of Bonds?

Understanding these fundamental terms—face value, coupon, and maturity date—lays the groundwork for a more complete comprehension of bond investing.

Just like stocks, bonds come with their own risks and returns. They are generally considered less risky than stocks but offer a lower potential return because you can never earn more than the total interest payments plus the face value. Remember investing in that hot tech startup with your stocks? It's super exciting but also pretty volatile. The risk for bonds? If interest rates skyrocket, the value of your bond can plummet, but as long as you can hold on until maturity, interest rate fluctuations will not affect your final payoff.

That's it for “Understanding Bonds and How They Work”. Keep reading for our next topic, where we'll delve into the different types of bonds you can invest in and the pros and cons of each.

Understanding the Types of Bonds

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Government Bonds

Welcome back, Pave Learners! In the previous Topic, we dipped our toes into the world of bonds—what they are, how they work, and the jargon you need to understand them. Today, we're diving deeper into the types of bonds available.

Let's start with government bonds, shall we? Think of these as the plumbing of the bond world ubiquitous and fundamental. They're highly liquid, so buying and selling them is easy. While they offer the safety and liquidity we all love, their returns often don't keep up with inflation, and their yields are generally low. So, you might be sacrificing growth potential for peace of mind.

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Corporate Bonds

Moving on, let's explore corporate bonds, which are diverse and have varying degrees of complexity. Corporate bonds often offer higher yields, enticing those looking for a better return. But remember, higher returns usually mean a company is trying to attract investors for a reason, and that reason may not always be in your favor. For example, the company might issue bonds to fund an expansion but then need help to grow. Treasury bonds do not have default risk, but corporate bonds do, meaning there is a chance the company goes bankrupt and you may not receive the face value of the bond at maturity.

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Municipal Bonds

Next, municipal bonds, which local governments, cities, or states issue. What's great about these bonds is that their income is often tax-free at the federal level and sometimes even at the state and local levels. Imagine relaxing in a tax-free oasis! However, these bonds may have lower liquidity than government and corporate bonds. This means that finding a buyer if you want to sell before the maturity date can be challenging, and you may need to sell for less than the total value if there is only one bidder.

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International Bonds

Last but not least, let's talk about international bonds. One of the big perks is the opportunity for currency diversification. If the dollar is weakening, holding bonds in a stronger currency could be beneficial. On the flip side, international bonds are subject to geopolitical influences that may not be easy to predict.

So there you have it, our journey through the bond world. Each type of bond offers something a bit different, and understanding these nuances can help you make informed decisions. Up next, we'll equip you with the right tools to navigate the intricacies of choosing individual bonds. Until then, happy investing!

How to Research & Choose Individual Bonds

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What Is Yield-to-Maturity?

Hello again, Pave Learners! In our last section, we explored the various bond types. Today, we're about to go on a trip to find the right bond for your investment portfolio.

So, how do you pick the right bond- or a portfolio of bonds- for you? Here's where it’s important to know what kind of investor experience you want.

First up is yield-to-maturity. For those who want something secure, with a stream of income, there are government bonds with a yield-to-maturity of 4%. This metric gives you an idea of the return you could expect if the bond is held until it has matured. But you should also compare this rate with the current inflation rate to ensure your investment would grow in real terms. That's your first tip: always cross-check the yield against current or expected inflation rates. It’s not the most adventurous choice, but there is always something to say about safety.

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What You Need to Know about Credit Ratings

Next, let's consider credit ratings. Those willing to take on more risk for higher returns can choose a corporate bond. A high yield of 6% was attractive, but you need to align that with a bond's credit rating. There are three major bond rating agencies: Standard and Poor s, Moody’s, and Fitch. They all analyze various financial ratios and competitive environments across all companies to assess the ability of a firm to weather a bad economic or sales cycle and still pay you your interest and the face value of the bond at maturity. Ratings measure creditworthiness and the expected loss represented by purchasing a bond from a particular company. They try to answer the question: what is the probability that the company issuing the bond will no longer be able to pay its obligations in the future?

The three ratings agencies have a ranking system that ranges from A, for the most creditworthy, to the least, rated C, with D representing default. Bonds with a rating of BBB- (from Standard and Poor s or Fitch) or Baa3 (from Moody’s) are the lowest ranks for bonds considered “investment grade,” with anything below considered more speculative. Lower-rated bonds are called high-yield or “junk” bonds because they have a material chance of going out of business during an unfortunate series of events. You have to compare the interest rate on the bond against its rating before deciding if it is a worthwhile investment.

If you decide, for example, to invest in a municipal bond that will fund your local school's infrastructure and also receive tax fee benefits, you need to consider liquidity. If the bond is not very liquid, meaning it might be tough to sell it before maturity, you have a decision to make. It should not be a deal-breaker if you invest with along-term horizon and want to support your community. If you want the flexibility to sell before the bond matures, keep an eye on liquidity.

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Bonds & Diversification

Lastly, let's talk about diversification. Suppose you are making room in your portfolio for a potential investment in international bonds. In that case, you want to do so if you can also benefit from any potentially profitable currency fluctuations. In general, allocating only a small portion of your portfolio to this type of bond is prudent.

So, in your treasure hunt for the perfect bond, consider the yield-to-maturity, credit rating, liquidity, and how it fits into your broader portfolio. Remember the considerations we discussed, and you'll be better equipped to make an informed decision.

Investment Strategies for Bond Investing

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Laddering Strategy

Welcome back, Pave Learners! Today, we're diving into strategies for navigating the world of bonds. Once you know what bonds are and how to pick them, the next step is to figure out a game plan. So, let's get to it.

First on our list is the Laddering Strategy. Picture this: you're climbing a ladder where each rung is a different bond that matures at a different time. Some may mature in 2 years, some in 4, 6, 8, or even 10. As you climb and reach each rung, you get your original money back plus interest. You buy another 10-yearbond with that money to keep the ladder going.

What's cool about this is that you're not simultaneously putting all your money into bonds that mature. This way, you always have money coming in.

The benefit of Laddering is that this strategy allows you to reinvest in new bonds or different assets if the current interest rates aren't working in your favorbecause it helps to spread out your interest rate risk.

Barbell Strategy

Now, let's talk about the Barbell Strategy. Imagine a barbell’s shape with two distinct weights on either end. On one side, you have long-term bonds; on the other, you have short-term bonds. The long-term bonds offer you higher returns, but they're a long commitment. The short-term bonds, on the other hand, are your quick grabs. When they mature, you decide where to put that money next.

Using a Barbell strategy prevents you from being locked into current interest rates for all your money. If rates go up, you can reinvest the short-term side of your barbell at those higher rates.

You keep some liquidity on hand for emergencies or big-ticket purchases. The downside is if rates fall, you have not locked in more of your money at favorable rates.

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Bullet Strategy

Finally, we have the Bullet Strategy. This one is for those of you who know precisely when you'll need your money back. Say, for example, you're saving up for your kid's college tuition, which is due in 10 years. You buy several bonds that will all mature around that time. But you buy these bonds over a few years to mix things up a bit in terms of interest rates.

The pros of this strategy: Your bonds will mature when you need the money, aligning with your financial goals. You’re organically spreading the interest rate risk by buying bonds at different times.

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Key Difference between Stocks & Bonds

Before we conclude, it's important to note a key difference between buying stocks and bonds. Unlike stocks, which are traded on a centralized exchange, bonds are traded over the counter. This means you'll typically need to buy them from brokers. However, if you're interested in U.S. Treasury bonds, you can buy them directly from the U.S. government. There is a way to take a hybrid approach and buy interest-rate ETFs. They are offered on short-term, intermediate-term, and long-term treasuries, corporate bonds, including junk, and even municipals (but municipal ETFs are not tax-free). They give you the ease of buying an extremely liquid instrument that gives you exposure to the asset class, but they are broad pools of instruments, more like a bond fund.

Alright, Pave Learners, that wraps up a deep dive into bond investment strategies. Remember, the right strategy for you depends on your own financial goals and risk tolerance.