If you don't really understand how bonds work, you certainly have company. The fact is, few investors are completely at ease in the mirrored house of bonds, where yields go up when prices fall and good economic news is considered bad. The lingo alone -- coupons, strips, zeros, yield curve -- may make you feel that the best course is one of blind faith.
But it's not as hard as it seems. This primer answers the questions many investors have, starting with the basic definitions and working up to the finer points of prices and yields.
What is a bond?
At its simplest, a bond is a loan.
For example, say you lend out $1,000 for 10 years in return for a yearly payment of 5% interest. Here's how that arrangement translates into bond-speak. You didn't make a loan, you bought a bond, or a note. The $1,000 of principal is the face value of the bond, the yearly interest payment is the coupon, and the length of the loan, 10 years, is the bond's maturity.
There's a good reason for the jargon. If you talk about lending money in these terms, it's easier to think of a loan as something that can be bought or sold like any other security. Seen in this light, making a loan is no different in spirit from buying a stock -- it's an investment.
Of course, unlike stocks, bonds promise to give you a specific return on your investment. That makes them ideal for people who want to increase their wealth without risking principal, such as a young couple planning to buy a house in two years, or a family with teenagers who will soon head to college. It also makes bonds a natural choice for retirees who want a guaranteed income from their investments.
Are bonds risky or safe?
Just because bonds have a reputation as a conservative investment doesn't mean they're always safe.
To begin with, don't forget that not all loans are paid back. Companies, cities, and counties occasionally do go bankrupt. U.S. Treasury bonds are considered rock solid. (In fact, economists even label the yield of the shortest-term U.S. bonds "the risk-free rate of return.")
Paradoxically, another source of risk for certain bonds is that your loan may be paid back early, or "called." While that's certainly better than not being paid back at all, it forces you to find another, possibly less lucrative, place to put your money.
The main danger for buy-and-hold investors, however, is a rising inflation rate. Sure, you're guaranteed to receive a fixed amount of money each year. But as prices rise, that amount is worth less and less. Worse yet, with your money locked away in that bond, you won't be able to take advantage of the higher interest rates that are usually available in an inflationary economy.
On the other hand, if the economy moves in the other direction, they can realize capital gains far beyond the bond's coupon rate.
Now you know why bond investors cringe at cheerful headlines about full employment and strong economic growth: These traditional signs of inflation hint that bond investors may soon lose their shirts.
What are the tax angles?
Generally speaking, any type of government bond will include a tax break. Because federal and local governments can't interfere with each other's affairs, income from local government bonds (municipals, or simply munis) is usually immune from federal taxes, and income from U.S. Treasury bonds is usually free from local taxes.
Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe from city, state, and federal taxes. (This happy state of affairs is known as being triple tax-free.) Of course, these breaks come at a cost: because tax-free income is so enticing to high-income investors, triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds.
These exemptions apply only to the interest paid by these bonds: Any capital gain from selling a bond for more than its purchase price is fair game for the tax collectors. And holders of corporate bonds are completely out of luck: city, state, and Uncle Sam will all take their share from their earnings.
How do I read a bond quote?
Bond quotes follow a few quirky conventions. Most business sections of daily newspapers (or financial Web sites) provide you with tables loaded with information. Prices are given as percentages of face value, with fractions like 1/32 as the last digits, not decimals. For example, take a bond that has just risen 8/32 to sell for 130 22/32. What it means is that an investor who bought the bond when it was issued at 100 could now sell it for a little more than a 30% profit. The hefty premium over face value is explained by the entry in the "rate" column: The bond's coupon of 11 7/8% is far above the current interest rates.
Typically, the last column on such tables shows the yield to maturity, which is an interest rate summarizing the bond's overall investment value.
One final detail: Keep in mind that more specifics about individual bonds are identified in shorthand. Abbreviations such as "m" means matured bonds, or "cld" means called, so look for the definitions in a key or an area labeled "bond tables explained."
How are prices and yields related?
If you buy a bond at face value, its rate of return, or yield, is just the coupon rate. But a glance at a table of bond quotes will tell you that after they're first issued, bonds rarely sell for exactly face value. So how much is the yield then?
Take a $1,000 bond with a 5% ($50) coupon that matures in the year 2020. If you manage to buy it for $800, you're getting two bonuses. First, you've effectively bought a bond with a 6.25% coupon, since the $50 coupon is 6.25% of your $800 purchase price. (The coupon rate adjusted for the current price is the bond's current yield). And there's more: although you paid $800, in 2020 you'll receive the full $1,000 face value. A more accurate calculation of return, yield to maturity, takes the resultant $200 capital gain into account.
Since yield to maturity is difficult to figure by hand, we've included use our bond calculator.
Type in a price of 80, meaning 80% of face value, and you'll see the yield rise from 5% to 7.98%. Notice that the lower price is associated with a higher yield. That makes sense, just as buying a shirt on sale gives you more value for your money.
What happens when rates fall? Say you bought that bond at a price of 80 when it yielded 7.98%. Now suppose that rates drop to 7%. Type "7" in the yield box of the calculator, and you'll see the price rise to about 85.9: over a 7% jump in value.
Given that a rate drop of less than one percentage point can cause a 7% price increase, you can appreciate why a 30-year bond can be a volatile investment. You can also see why bond traders -- who must pay attention to the subtlest fluctuations in yields -- measure rate changes in tiny increments, or basis points, each equal to 1/100 of a percentage point.
Many investors, tempted by the possibility of quick profits, try to speculate on moving interest rates -- but it's a tough game to play. Bonds are even trickier to time than stocks. So unless you fancy yourself a bond expert, you should probably be prepared to hold your bonds for the long haul, or consider a bond mutual fund with an experienced pro at the helm.