Bonds: How They Work and How to Invest

Bonds are debt securities governments, municipalities, and corporations issued to raise capital. When you buy a bond, you are lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value at maturity. Let us have a detailed look into how bonds work and how to invest in them.

weighing bonds

What to Know About Bonds

Bond Face Value (Par Value)

The bond's face value, or par value, is the amount it will be worth at its maturity date. It is the reference amount that the bond issuer uses to calculate interest payments. For example, if a bond has a face value of $1,000, the bondholder will receive $1,000 when the bond matures. The face value is also the amount on which interest payments are based.

Bond Coupon Rate

The coupon rate is the interest rate that the bond issuer agrees to pay annually on the face value of the bond. This rate is expressed as a percentage. For instance, if a bond has a face value of $1,000 and a coupon rate of 5%, the bondholder will receive $50 in interest payments each year until the bond matures. The coupon rate is fixed when the bond is issued and remains constant throughout the bond's life.

Bond Maturity Date

The maturity date is the date on which the bond will mature, meaning the issuer will repay the bondholder the face value of the bond. Bonds can have varying lengths of maturity:

• Short-term bonds mature in 1 to 5 years.
• Medium-term bonds mature in 6 to 10 years.
• Long-term bonds can have maturities extending beyond 10 years, with some reaching up to 30 years or more. The maturity date is crucial for investors as it determines the time frame over which they will receive interest payments and the return of the principal amount.

Bond Issuers

Bonds can be issued by various entities, each serving different purposes and carrying varying levels of risk:

        i.            Governments: These bonds are considered the safest because they are backed by the full faith and credit of the issuing government. Examples include:

• Treasury Bonds (T-Bonds): Long-term investments with maturities ranging from 10 to 30 years.
• Treasury Notes (T-Notes): Medium-term investments with maturities from 2 to 10 years.
• Treasury Bills (T-Bills): Short-term securities with one year or less maturities.
1. Municipalities: Municipal bonds, or "munis," are issued by local governments or agencies. They are often used to fund public projects such as schools, highways, and hospitals. These bonds are primarily tax-exempt, making them attractive to investors in higher tax brackets.
2. Corporations: Corporate bonds are issued by companies to raise capital for business activities like expanding operations, acquisitions, or funding research and development. They generally offer higher yields than government bonds to compensate for higher risk. Corporate bonds can be classified into two categories:
• Investment-Grade Bonds: Issued by companies with a high credit rating, indicating a lower risk of default.
• High-Yield Bonds (Junk Bonds): Issued by companies with lower credit ratings, offering higher yields to compensate for the increased risk.

How to Invest in Bonds

a)      Direct Purchase Investing in bonds directly involves buying them from the issuer or through a broker. Here are the main ways to directly purchase bonds:

Government Bonds: You can buy government bonds directly from the Treasury through online platforms like TreasuryDirect in the U.S. or through the Dhow CSD portal in Kenya. This is a straightforward way to invest in bonds, as it involves lower fees and no intermediaries.

Corporate and Municipal Bonds: You'll generally go through a broker to buy these bonds. Brokers can access various bonds and offer guidance on which bonds might suit your investment goals. When purchasing through a broker, consider fees and commissions, which vary.

b)      Bond Funds Bond funds are Mutual Funds or exchange-traded funds (ETFs) that invest in a diversified portfolio of bonds. Here’s why you might consider bond funds:

Diversification: Bond funds pool money from many investors to buy various bonds, spreading out the risk associated with any single bond issuer.

Professional Management: These funds are managed by professional fund managers who make investment decisions on behalf of the investors.

Liquidity: Bond funds offer greater liquidity than individual bonds, as you can buy or sell shares of the fund on the open market.

c)      Bond Laddering Bond laddering is a strategy that involves buying a series of bonds with different maturities. Here’s how it works and its benefits:

How Bond Laddering Works: You purchase bonds that mature at regular intervals, such as every year or every few years. As each bond matures, you reinvest the principal into a new bond at the end of the ladder.

Managing Interest Rate Risk: Staggering the maturities reduces the risk associated with interest rate fluctuations. If interest rates rise, you can reinvest maturing bonds at higher rates. If rates fall, you still benefit from the higher rates of the longer-term bonds on your ladder.

Steady Stream of Income: A bond ladder can provide a regular, predictable income stream, as you receive interest payments from multiple bonds with different maturities.

Bond Valuation

Bond valuation is the process of determining the fair price of a bond. The value of a bond is the present value of its expected future cash flows, which include periodic interest payments and the repayment of the face value at maturity.

Consider A bond with a face value of $1,000, a coupon rate of 5%, and 10 years to maturity. If the discount rate is 4%, calculate the bond price. (the formula and the worked-out answers are in the attached photos)

Bond value formula and example

 Is it Profitable to Buy Bonds?

Bonds offer lower returns than stocks but provide steady income and are less volatile.

Bonds Profitability Determinants

1. Interest Rates: Bond prices are inversely proportional to interest rates. When rates go up, bond prices fall, and vice versa.
2. Credit Quality: Higher credit quality usually means lower yields but also lower risk.
3. Economic Conditions: During economic downturns, bonds are safer investments than stocks.

Benefits of Investing in Bonds

        I.            Stable Income Bonds can provide a steady income through regular interest payments. This can be appealing to retirees or others seeking consistent cash flow.

     II.            Capital Preservation Investing in high-quality bonds, such as government bonds, can help preserve capital. These bonds are safe, and the principal is returned to the investor at maturity, barring any default.

  III.            Diversification Including bonds in your investment portfolio can provide diversification, reducing portfolio risk. Bonds behave differently than stocks, so when stock markets are volatile, bonds can help stabilize your portfolio.

  IV.            Tax Advantages Municipal bonds, for instance, offer tax advantages. Interest earned on municipal bonds is exempt from federal income tax and sometimes state and local taxes.

Bonds Considerations and Risks

1.      Interest Rate Risk: The value of bonds can fluctuate with changes in interest rates. When interest rates rise, bond prices fall, and vice versa. This is important if you plan to sell bonds before they mature.

2.      Credit Risk refers to the possibility that the bond issuer will default on its obligations, failing to make interest payments or return the principal. Government bonds have low credit risk, while corporate bonds, especially high-yield bonds, have higher risk.

3.      Inflation Risk Inflation can erode the purchasing power of the interest payments and principal returned at maturity. This risk is particularly relevant for long-term bonds.

4.      Market Risk Bond prices can be affected by broader market movements, economic conditions, and investor sentiment, potentially impacting the value of your investment.

Bonds can be a valuable part of a diversified investment strategy, offering stability, income, and potential tax benefits. Understanding the different ways to invest in bonds and the associated risks can help you make informed decisions to meet your financial goals.