Breaking Down Bonds
Despite being a common investment vehicle, bonds can often be misunderstood, in our view. Many investors think bonds are a simple way to earn a safe return, but the reality can be quite different. In fact, bonds (often called fixed income) have many nuances, complexities and unique characteristics, which are important to understand. The better you know bonds, the better you’ll be able to decide whether they have a place in your portfolio strategy.
As an investment manager, Fisher Investments doesn’t focus on any one asset class—we manage a variety of strategies including stocks, bonds, cash and other securities. The optimal portfolio strategy for you will depend on your specific investment objectives, time horizon, cash flow requirements, outside income and assets, and any restrictions or customizations you may have.
The Basics
A bond is effectively a loan—a debt security issued by a company or government seeking capital. When you buy a bond as an investment, you own a contractual promise by the bond issuer to pay you interest (called a coupon payment) at scheduled times over the bond’s life and repay you the principal amount borrowed at the end of the contract period (called the bond’s maturity date). Unlike the much less certain returns of a stock investor, the bond issuer is required to pay investors according to the terms of the contract or indenture of the bond. For this reason, bonds generally have lower expected volatility risk than stocks—and historically, lower returns.
Companies issue bonds to raise capital for new plants and equipment, mergers and acquisitions, stock buybacks or other uses. Governments issue bonds to finance public works projects or other spending in excess of tax revenue. Unlike stocks, bonds are often traded over-the-counter through a network of dealers instead of on an exchange. Fixed income exchange traded funds (ETFs) are securities designed to track a specific bond market index and are an exception to this rule as they are traded on an exchange.
When a company or a government issues bonds, it usually divides the bond issue into pieces worth $1,000 each so investors can buy them in units. This value, called the face value, is the amount the issuer promises to repay at the bond’s maturity. For instance, if a company issues $1 million in bonds in units of $1,000, investors can buy as much—or as little—of the issue as they would like in lots of $1,000. Bond prices are often depicted as a percentage of face value. Generally, a bond trading at 100 means it would cost $1,000. A bond trading at 98.5 would cost $985.
A bond trading at its face value is said to be trading at par. An investor who buys a bond at par will have a return equal to the interest rate of the bond assuming they hold it until the maturity date, reinvest interest received at the same yield-to-maturity and, of course, the issuer is solvent throughout. A bond trading above face value is said to be trading at a premium. This is generally due to the bond having a coupon interest rate above those of comparable, newly issued securities. An investor who buys a bond at a premium and holds it to maturity will get a return somewhat less than the coupon interest rate.
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