JumboCash: Bond market basics

 When people think about different types of investments, stocks are often first in their mind, given their high upside and high risk. Although they lack the glamour of stocks, bonds can help investors achieve steady income and reduce the overall risk of their portfolio. This week, we will discuss how bonds work, why bonds are an important part of the economy and the key risks related to bonds.

Bonds, commonly referred to as fixed-income or debt, are essentially IOUs.  A lender gives a borrower money in the present in exchange for a stream of payments in the future. Typically, the borrower will repay the loan with semiannual coupon payments (in finance, coupon is a fancy word for interest). On what is referred to as the maturity date, the borrower will repay the lender the face value of the loan — in other words, how much money they initially received from the lender. Therefore, in the long-run, the lender earns a return, since they are repaid the principal plus interest payments, whereas the borrower benefits from a large chunk of cash in the short-term.

Major borrowers include government entities, such as municipalities, states and sovereign governments, but companies also constitute a large part of the bond market. Debt can have a bad connotation, but debt is the lifeblood of the economy, allowing governments to build infrastructure, businesses to open new stores and individuals to pay for college. Once borrowers pay off their loans, the lender has more money to lend, fueling further economic growth.

So, what factors drive the riskiness of bonds? As you can guess, not all borrowers are able to repay their debt. Before issuing bonds, credit rating agencies evaluate the ability of the borrower to repay. The nomenclature of ratings agencies varies, but the ratings generally range on a scale from AAA to D, with AAA being the safest and D the riskiest.

If a credit rating agency deems that a company will have difficulty repaying its loans, investors will be compensated for such riskiness with higher interest payments. Hence, they will earn a higher return for a risky bond. On the other hand, bonds from a creditworthy entity like the U.S. government will have a low return, as there is a very low chance that the government will be unable to repay its debt.

In addition to the creditworthiness of the borrower, the time horizon of the bond is also an important risk. It’s pretty intuitive: Wouldn’t you want to be compensated more for lending your money for 30 years, as opposed to only 10 years? 

Now, what makes bonds safer investments than stocks? In theory, there is no limit on how much money a company can make, so the value of the company (as well as the value of your stocks) can increase substantially. With bonds, the coupon payments and face value are fixed when the loan is agreed upon. Hence, there is more certainty around the potential return on the security.

Stocks might seem sexier due to their high potential returns, but bonds are an equally strong component of a balanced portfolio.