Bonds are loans to governments or corporations that can be traded on a market. A bond always comes with a maturity date (when the principal will be paid back), plus an interest rate and payment schedule (whether annual, semi-annual, quarterly, or monthly).
For example, let’s say the TD Bank needs money and issues a 10 year bond at 4%, paid annually. Chuck buys $10K of the original issue. On his statement it says 10,000 units at $1 / unit.
After a year, Chuck needs the cash. He goes to the market and sells the bond. The new owner gets the bond with only 9 years left to maturity, and may be willing to pay the $1 / unit or a price that’s higher or lower. The reason a buyer would pay par, something higher, or something lower depends on two factors:
- The likelihood of TD paying the principal and interest payments (bond quality)
- The bond’s annualized return compared to other competitive investments
If within that year, the bank’s future was affected positively or negatively, the quality of the bond will change and this gets reflected in the unit price. The value is also affected by other investments. If the new buyer can purchase a no risk, government backed GIC that pays 5%, why would he or she pay full price for Chuck’s 4% bond that carries, at least, some risk?
Yield
Calculating a bond’s yield involves using the interest rate on the original bond divided by what the new owner pays, plus the difference in capital between what the new owner pays and the amount of money that gets returned upon maturity.
For example, let’s say the new buyer is willing to pay $1.05 / unit, or $10,500 for Chuck’s bond. The two components of the equation are:
Annual interest component: $400 / $10,500 = 3.8%
Annualized capital appreciation (depreciation): $10,000 – $10,500 = ($500)
-$500 / 9 years = -$55 / year
-$55 / $10,500 = -.5% / year
3.8% – .5% = 3.3% annualized return
The new owner gets $400 / year on his or her $10,500 investment (3.8%), but loses $500 when the bond matures. So together, the annualized yield is 3.3%. In a second example, The TD bank could get in trouble (like Blackberry) and the new buyer is only willing to pay $.70 / unit. Then the numbers would look like this:
Annual interest component: $400 / $7,000 = 5.7%
Annualized capital appreciation (depreciation): $10,000 – $7,000 = $3,000
$3,000 / 9 years = $333 / year
$333 / $10,500 = 3.1%
5.7% + 3.1% = 8.8% annualized return
That’s the way bonds work. Interest rate, payment frequency, and maturity date are all established upon the original issue. Then they can be traded many times before the maturity date is reached.
Ratings
Bonds are loans to governments or corporations, paid and guaranteed only by them (so you can actually lose your money). As a result, bonds are rated for quality (the ability of the debtor to repay interest and principal). High quality bonds are rated between A- and AAA+. Bonds rated below BBB (down to DDD-) are considered junk. The higher the risk, the greater the interest should be.
Note: you always need the rating in order to interpret the return.
Volatility and fees
Bonds fluctuate in inverse relation to interest rates. So if interest rates go up, bond values typically go down. Why? Because if GICs are paying 6%, who wants your 5% bond? Likewise, if GIC rates fall to 3%, everyone is now willing to pay a premium for your 5% bond. But this change in value is mitigated if you hold your bond to maturity.
And owning a bond is like owning real estate, the commission is bore by the seller. So the minute you buy one, it’s instantly worth 1-2% less (and this will be reflected on your statement). But if you hold your bond to maturity, no sales commission will be paid.
Summary
Bonds are a great addition to any investment family—you just have to understand them. Start with high-quality, short term bonds that can easily be held to maturity. This way you’ll avoid much of the inherent risk and always get what you bargained for.