What is a bond?

Welcome to the thirteenth post of The Invested Counsel—thoughts about financial planning for young lawyers.

Up until now, I’ve mostly talked about investing in stocks for the long term. And that makes sense, since it is through long-term investing in stocks (and in particular, through a single, globally diversified, total market, low cost, market cap-weighted equity index ETF) that normal people can become rich.

But stocks are not everything. In this post, I’m going to talk about bonds. My goal is to explain bonds in the simplest manner possible. While most young lawyers are comfortable thinking about stocks, bonds are often seen as weird and confusing. And that makes sense, because bonds can act in ways that are counterintuitive.

Bond basics.

Bonds are loans. That’s pretty much it. When you buy a bond, you are loaning money to a government or a company, and they promise to give you your money back in the future, plus interest. The company or the government that you loan money to is the “issuer,” since they issue the bond to you. You are the “purchaser,” and when you purchase the bond, the money you pay is the loan to the government or company. The bond itself is the evidence of the loan, and represents the right to get payments from the issuer.

There are many different types of bonds. Some are issued by governments (like the United States, or a particular state, or city), while others are issued by companies. Some are for short periods of time (e.g., a few months), while others are for much longer (e.g., 30 years). Some bonds are secured (meaning that there is some collateral that can be seized if the issuer defaults, or fails to pay back the loan), and some are unsecured (meaning that the only thing backing the bonds is the promise of the issuer that they will pay back the loan).

Depending on these characteristics, the bonds will pay different interest rates. The more likely an issuer is to pay back its bonds, the safer the bond is as an investment, the less interest the issuer will pay. That is because the purchaser knows they will get their money back, so more people are willing to purchase those bonds. On the other hand, if an issuer is likely to have trouble paying back the bonds, the riskier the bond is as an investment, and the more the issuer will have to pay in interest to get the loan. A purchaser that buys a bond from a risky issuer is not going to want to invest in that issuer’s bonds unless they think it is worth it, i.e., they are going to get more for their money (via a higher interest rate).

For example, a bond issued by the United States government is considered one of the safest investments available. The idea is that the U.S. is always going to pay its bondholders, since the federal government is considered strong and stable. (You can dispute that or not, but for personal finance purposes, the U.S. is the safest bet around.) As a result, bonds issued by the U.S. government will pay some of the lowest interest rates available. In contrast, a bond issued by a company that is not in great financial shape will likely pay a much higher interest rate.

Similarly, in most (but not all) situations, a bond that has a longer term will pay higher interest rates than a bond with a shorter term. That is, a bond that will pay everything back in a year is likely to offer a lower interest rate than a bond that will pay everything back in 30 years. That is because there is a lot more that can go wrong in 30 years, so a 30-year bond is considered riskier than a 1-year bond, and as we saw above, riskier bonds need to pay higher interest rates to get people to purchase them.

Why bonds are confusing: they can be bought and sold.

If that was it, then bonds wouldn’t be too complicated. When deciding whether to invest in bonds, you could evaluate them based on their characteristics and make the decision that was right for you. You could buy a safe government bond and accept a lower interest rate, or take a chance on a less safe bond and get a higher interest rate, but run the risk of not getting paid back. Pretty straightforward.

The issue with investing in bonds is that once a bond is purchased, it can be sold to someone else. And as is true with everything, if something can be bought or sold, it can be bought or sold at any price that two willing parties are able to agree on. Thus if you buy a bond for $1000, and it guarantees an interest rate of 5%, you can sell it for $1000. Or you could sell it for $800. Or $1200. Or whatever you want. The thing that confuses people is that market price of a bond can become divorced from the original purchase price of the bond, and in turn the amount that the bond will eventually pay back.

The market price of a bond can change because of something that happens to the issuer of a bond. For example, if a company issues a bond, and then it turns out that it may go bankrupt, people are not going to want to buy that bond as much. Since it will be less appealing to buy, the market price of the bond will go down. On the other hand, if the issuer’s finances improve, then people may be more interested in buying the bond, and its price will go up.

Why bonds are really confusing: interest rates.

However, there is one factor that influences the prices of bonds more than anything else: interest rates. When we talk about interest rates, we’re talking about the “prevailing interest rates” of all the bonds and loans that are being issued right now. Bonds and loans are being issued at all times, by all sorts of institutions to all sorts of institutions and people. Those “prevailing interest rates” are determined by a very complex interplay of things being done by the government and the economy and banks and everyone else. It’s not important to understand how “prevailing interest rates” are set for now; just understand that they all generally move together.

As a result, sometimes, “prevailing interest rates” go up. And sometimes “prevailing interest rates” go down. The reason why this is important for investing in bonds is the following: someone who wants to invest in bonds always has two basic choices. They can either buy a new bond (which is going to use the “prevailing interest rates” at that time). Or they can buy an old bond (whose interest rate is set, and does not change). People will be more likely to buy an old bond if the interest rate on that old bond is higher than the interest rate on a new bond. And people will be less likely to buy an old bond if the interest rate on the old bond is lower than on a new bond.

An example may be helpful. Say you had an old bond that you purchased a few years ago, and it had 10 years left to pay back, and it was paying 5%. And say that “prevailing interest rates” increases, and so someone could buy a new bond that would pay the same amount back in 10 years, but was paying 6%. The new 6% bond would be better than the old 5% bond, and so people would be less willing to buy the old 5% bond, and the price of that bond would go down. On the other hand, if prevailing interest rates went down, and new bonds were only paying 4%, the old 5% bond would look better and its price would go up.

The problem this poses to investors is that interest rates are unpredictable, and can change relatively quickly. As a result, even if an issuer pays a bond back exactly as promised, the price of that bond can be volatile—that is, it can be squiggly, just like stocks. While bonds are generally not as squiggly as stocks, they can be quite squiggly at times, due to fluctuations in “prevailing interest rates.”

If you hold the bond until it pays you back (i.e., until it matures), then the fluctuations in price don’t matter to you. But if you want to sell your bond before then, the prices will matter a lot to you. And since most people don’t hold all of their bonds until maturity, you will generally have to deal with the squiggliness of bond prices caused by changes in “prevailing interest rates.”

How to invest in bonds.

There are two main ways to invest in bonds. You can either invest in individual bonds, or you can invest in a bond fund that holds a lot of bonds. Most people (including most young lawyers) that want to invest in bonds should invest in a bond fund, because a bond fund will be diversified across lots of different issuers and types of bonds. That diversification makes them safer than holding individual bonds, since it is possible for an individual bond to go to zero, while it is pretty much impossible (excluding an asteroid hitting the earth) that a bond fund would go to zero. On the other hand, the value of a bond fund will still squiggle because of many things, including “prevailing interest rates.”

So, should you invest in bonds?

Maybe, maybe not. Before deciding how much to invest in bonds, you need to decide how much you’ll hold in the last major asset bucket. I’ll cover that in next week’s post.

That’s all for now. Have a wonderful week.

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