Bond Basics

Disclaimer : Bonds and bond markets are exponentially more complex than the scope of this article.

No, not that Bonds!

If you’re like me, then you want to get into bond investing, but don’t yet fully understand how they work.

The full mechanics and math stuff for Bonds, as well as the various types and classifications, requires a lengthy explanation. While we’ll probably do this at some point in the future, utilizing the power of copy and paste, today we’re just going to go over the basics.

For our purposes, let’s just assume we’re buying government bonds, or from some other issuer that is not going to default. A default doesn’t mean you lose all of your money, though it could. Most often you just receive a portion of your investment back. But it could mean total loss, minus whatever interest you’ve already received.

Oh, and our pretend bond can’t be called. Can’t default, and can’t be called. (When a bond is called, you receive the par value, as you would at maturity. Sometimes with a premium, sometimes not).

You want to understand the difference between Market value and Par value (or Face value). The par value of a bond is the value on the certificate. Whereas Market value is what you’d buy or sell the bond for on the market. Depending on when the bond was issued and at what interest rate, you might pay $150 for a $100 bond. Or alternately you could pay $90 for a $100 bond. In either case, the $150 or $90 would be Market value. In both cases, $100 is the par value.

In our scenario, we just want to buy the $100 bond and hold it 20 years to maturity. At maturity, we get our $100. During that time, the bond will pay a certain % in interest On the Par value of the Bond. Let’s say our bond has a 5% interest rate *(coupon rate). Figuring the current interest rate is easy, that’s the one set by the Fed that you hear about all the time. Coupon rate is the interest rate at the time the bond is issued, and is fixed.

So let’s say the market value of our 5% bond drops to $1 (I don’t think that’s even possible), we would still receive $5 annually, or 5% of the par value of the bond.

Then what would happen at maturity? You get the principal back at maturity regardless of market value.

If we sold the bond, we would lose $99 minus any interest already received. If we hold the bond to maturity, we get the par value back, in our case $100 (plus any interest we had been paid over the life of the bond).

But what if the market value is $200? Well, then I guess we should have sold it before maturity. Otherwise at maturity we would only get back the par value of $100.

Another example - $1000 8% 20 year bond issued 15 years ago, would sell today for well over $1000, but you would still only get the $80 interest payments and the $1000 on maturity.

Where does market value come from? Change in interest rates. When rates go up, market value goes down. When rates go down, market values go up. Why is this? Take our previous example of the $1000 bond at 8%. Remember that the 8% is paid on the par value, so get $80 a year as long as we own the bond. If the interest rates drop to 1%, we still receive $80 annually. However, we can now sell the bond for more than we paid for it, for about $1,340.

If the person buying the bond holds it to maturity, in this case for 5 more years, they would make $60 profit. ($1000 par + $400 from interest paymetns).

What about us? We already held the bond for 15 years. We already collected $80x15, or $1200. By selling now, we still lock in a profit of $1540, ($1340 market value - $1000 par value) + $1200 interest received = $1540.

Bet you wish you had a time machine.

“But Rocky!” you say, “Interest rates are near-zero! They have nowhere to go but up!”. And indeed, they are going up. What happens to bond values now? They drop. Let’s say our $1000 was bought at 1% interest, and 15 years later rates go to 8%. Our bond now has a $720 market value. By selling now we would lose $280, minus the $150 in interest we collected, coming to a loss of $130. If we continue to hold to maturity, we’ll get the $1000 par back in addition to another $50 in interest, for a total profit of $200.

The person buying this bond at market value would make $280 + $50 at maturity, for $330.

There’s basically no point in buying newly issued bonds right now. Not for people at our income level. However, it might be worth your time to research bonds and bond trading, then looking discount bonds that meet your needs.

TLDR

Buy government bonds when interest rates are high.

That’s it. Poor people will not benefit from buying bonds when interest rates are so low.

Bond-based ETFs are more practical, and accessible, for low-income investors.

Remember to check that the ETF you’re buying is currently paying dividends. Just because it’s on Robinhood and promoted by a YouTuber doesn’t mean it’s paying monthly interest!