What is a Bond and How Does It Work

Jun 2, 2022 | Getting Started, Investing, Saving & Investing

Bonds 101: Principal, Maturity, and Interest

You have probably heard of a bond and understand that it is a “safe investment” that should be held in most portfolios. Although people understand this premise, few actually know the mechanics of bonds and how they work. Simply, a bond is an IOU or a loan between an investor (debt holder) and an institution. The IOU can be between you as the investor and the United States of America (US Treasury), local governments, or even private sector companies like Coca Cola.  Let’s take a deeper look under the hood with an example. If you are looking for a safe investment and a fixed interest rate, you may want to invest in U.S. Treasury Bonds. When investing in Treasury Bonds, you are lending money to the United States government. In return, the government agrees to pay you that money back, plus a stated interest rate, after an agreed upon amount of time.  There are many important considerations when investing in a bond but let’s focus on three key functional parts. 

  1. Principal – the lump sum the investor is lending to another party
  2. Maturity – the date when the bond issuer (borrower) will return the principal to the investor (also known as the duration)
  3. Interest – the percentage amount owed to the person buying the bond (also known as the coupon)

Let’s look at how these three pieces play together.  Imagine your local city wants to build a new airport.  Airports are not cheap and one way the city may finance the project is by issuing bonds to the public for purchase.  For instance, they might issue hundreds of $5,000 bonds for purchase with the terms as follows: 4% interest (coupon), for 10 years (maturity).  That means the bond buyer (who is lending the money to the institution) would purchase the bond for $5,000 (principal) and expect in return $200 of interest each year for the next 10 years.  Depending on the current interest rate environment, the investors’ goals, inflation, tax rate, etc., this might be an attractive offer.  

This certainly sounds good and a “fair” deal for both parties. However, what if interest rates rise and future bonds of equal size and shape are paying 5%, 6%, or even 10%? As the investor, would you be happy with your 4% bond if you knew that similar bonds were now being issued at and paying these higher rates? Probably not. The 4% bond the investor bought would not seem very attractive which leads us into Bonds 201. 

Bonds 201 – The Benefits and Risks Involved When Investing in Bonds 

Bonds play an important role in most investors’ portfolios and may help you reach your financial objectives; however, they are not without risk. Bonds typically provide a more predictable outcome with less volatility than the stock market. The reason for this more predictable outcome is that each bond typically has a stated interest rate and time commitment to pay the bond holder back. Additionally, if we look at corporate bonds and imagine a scenario where the issuing company fails, bond holders are paid back before stockholders.  

Like most investments, bond investments involve some risk.  For Bonds 201, we will focus on three of the major risks when investing in bonds: interest rate risk, inflation risk, and default risk. 

Interest Rate Risk

Interest rate risk is the risk of bonds losing current value due to rising interest rates. Because your current bond paying a lower interest rate is less attractive than a new bond paying a higher interest rate the price of your existing bond would drop. As a result of the decrease in price/value you would potentially lose money if you decided to sell the bond at that time. However, if you chose to hold on to your bond until the bond reaches the finish line (maturity date), you would get your principal back in full per your original agreement with the issuer. There is a caveat where this repayment may not happen, but we will discuss this in the default risk section below.

Inflation Risk

As an investor, it is important to understand how inflation can impact your investments and your purchasing power in the future. This is known as inflation risk. We can all probably agree that the costs of goods and services will be more expensive in the future than they are today.  Since you do not know how long you will live, how much costs will rise in the future, if you will need nursing home care for an extended time, or how your personal bucket list will evolve, this makes inflation risk a concern. To gain a better understanding of how inflation can impact bond investments, let’s use our bond example from the Bonds 101 section. If our bond is paying 4% and inflation is growing at a pace faster than our stated interest rate, our money is losing purchasing power. We are locked into this rate for the life of the bond and losing purchasing power can negatively impact our day-to-day spending or force us to downsize our standard of living. Your current bond not paying enough to keep up with inflation is a risk that with a proper investment strategy can be mitigated.

Default Risk

Lastly, let’s look at default risk, again using our airport bond from the example in the Bonds 101 section.  If the airport had a significant negative change in its financial situation due to a decrease in revenue, how would it impact the city’s ability to make interest payments and repay principal? The airport may be faced with making hard choices like reducing staff, delaying non-critical repairs/updates, or even defaulting on payments to bond holders of the new airport.  How might this happen? There are a number of scenarios that could generate this risk, for example: there could be another global pandemic where air travel is halted, or the airport could face competition from a new travel technology like Hyperloop.

As you can see, although bonds are on the safer side of the risk spectrum when it comes to investing, they do come with some inherent risk. It is important to have a proper strategy to help maximize your returns while at the same time mitigating your risk. Consider having an educational conversation with a GreenUp Wealth Advisor on how bonds may help with your unique situation.

Author

  • Kyle Barclay, CFP®

    Senior Vice President | Wealth Advisor | Kansas City -- Kyle is a CFP® and has been in the financial services industry advocating for clients helping them reach their financial goals for over a decade. Prior to joining GreenUp Wealth Management in April of 2021, Kyle served clients as a financial advisor at a broker dealer and a registered investment advisor for 10 years. Before working in financial services, Kyle spent 8 years working in management for independent grocery stores across Missouri and Kansas always keeping a customer first mentality. As a leader in the grocery industry, he focused on enhancing each store’s customer experiences by tailoring each store’s product options, implementing new customer services, and training employees how to better understand how to best serve their customer in their respective departments.

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