Monday, July 26, 2010

Bond Basics

What Is a Bond?

A bond is a loan. When you buy a bond, you are lending money to the bond's issuer. Generally, the loan is for a fixed amount of money, the principal -- or face amount -- for a fixed length of time. At the end of that time, the bond is mature; the borrower pays off the loan by paying off the face amount. Most often, the loan is at a fixed rate of interest, the interest being due on a fixed schedule during the life of the loan (e.g., quarterly or yearly).

Technically, not all fixed income instruments are bonds. However, in this post I am using the term bond loosely to include not just bonds, but other fixed income instruments such as bills, notes and certificates of deposit as well.

Basic Bond Math: Calculating Interest

You may remember the fundamental bond equation from high school:
I = PRT Interest=Principal x Rate x Time

Thus, if you own a $1,000, 5-year, 5% bond that pays interest annually, the amount of interest you will receive each payment is
Interest = Principal x rate x time
Interest = $1,000 x 5% per year x 1 year = $50

If you receive interest payments twice a year, you are receiving a payment every 6 months, or every 0.5 years, and each payment is
Interest = $1,000 x 5% per year x 0.5 years = $25

In either case, you will receive $50 per year, and $250 over the 5-year life of the bond.

Calculating Interest Rate

Since I = PRT, it follows that (dividing each side of the equation by PxT)
I/PT = R, that is
Rate = Interest divided by Principal x Time

Thus, if you own a $1,000 bond and received interest payments of $25 every 6 months (i.e., every 0.5 years), your interest rate is
Rate = Interest / (Principal x Time)
Rate = $25 / ($1,000 x 0.5 years)
Rate = 2.5% / 0.5 years = 5% / year

Advantages and Disadvantages of Bonds

My mother used to buy five-year treasuries when they were issued, and hold them until they matured. If you use her five-year treasuries as a proxy for "bonds," then, as compared to other possible "investments" such as cash, stocks, real estate and precious metals, with bonds:
  • Your principal is safe, you will get it back when the bond matures
  • You have a guaranteed source of income
  • You know how much you will earn, and when
  • You know how much you will receive when the bond matures
  • The value of your holdings does not appear to vary from day to day (e.g., compared to a portfolio of stocks)

In general, bonds have traditionally been a safe, conservative investment. They are especially useful when you have a future obligation due on a specific date. For example, if you plan to make a down payment on a new home in two years, you might buy a bond that matures when you expect to make that down payment.

The primary disadvantages are
  • Loss of flexibility compared to cash. You are "locked in" until the bond matures.
  • Historically, the return on bonds has been somewhat less than that of some other forms of investment.

Caveat: Bond Funds are Not the Same as Bonds

The above analysis applies to individual US Treasuries or FDIC insured certificates of deposit bought when they are issued and held until maturity. Note that with bond funds, you do not hold individual bonds. As a result, there is no way to know what rate of interest, or how much income, you will receive. With bond funds there is also no maturity date, and no date at which the return of your funds is assured. In many respects, bond funds are very different animals from individual bonds.

At least initially, I am trying to be as conservative as possible in this analysis. Therefore, in addition, I am assuming the bonds mature in no more than about five years. If these assumptions all hold, even my mother could sleep nights. If not, you will generally incur some additional risk in the form of:
  • Interest rate risk, or
  • Inflation risk, or
  • Credit risk.

How Much is an Investment Worth?

In the next post in this series, we'll determine fair value for a bond. That post will introduce a fundamental technique that can be used, and is used, to evaluate many kinds of investments -- not just bonds.

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