Bond Basics

December 12, 2020
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The basics of corporate bonds...

Corporate bonds are debt instruments issued to the public by companies. They're typically issued in increments of $1,000, known as the "par value" or "principal" of the bond.

Unlike a share of stock, a bond is a legal contract between the issuer (company) and buyer of the bond. That makes them much safer than stocks. The buyer is legally entitled to collect the full $1,000 par value on the stated maturity date of the bond.

Along the way, the buyer is also entitled to receive regular interest payments (usually every six months) for lending the money. The company doesn't have a choice... It has to pay you.

That's how most bonds work. And most bonds are pretty ordinary investments... They yield between 2% and 5%, on average, per year – almost exclusively from the interest.

Most bonds, once issued, trade regularly on the secondary market. Their prices are determined by supply and demand. Here's what's important to remember... Regardless of what you pay for the bond, your legal right to collect interest payments and the $1,000 principal at maturity doesn't change.

Some bonds trade for less than the $1,000 par value. When that happens – in addition to the interest you earn – you can also earn capital gains. That's the difference between the par value and the price you pay for the bond.

Yield to maturity ("YTM") is a key term you need to understand when buying bonds...

It's simply the annualized return you can expect to receive if you hold the bond to its maturity. YTM is a combination of the interest you'll receive while you hold the bond and the capital gains you'll earn when you're paid the full $1,000 par value at maturity.

Bonds are much simpler and easier to analyze than stocks. That's because they're binary.

With corporate bonds, you only have two possible outcomes: The company either pays you what it owes you, or it doesn't. That's it... Because you know exactly when and how much you are going to get paid, you can completely ignore daily fluctuations in the price of the bond after you've bought it.

As long as the company pays you all of your interest and principal, you know the return you'll make on your investment at the time you buy the bond. It's the complete opposite with stocks, where you only know your return when you sell them.

If the company doesn't pay you what you're owed, it's considered to be in "default" on its debt and lenders can force it into bankruptcy.

So when buying a corporate bond, the only question is: Will the company stay in business and pay you all of your interest and principal through maturity?

It's really that simple.

Just like stocks, bonds trade in a public market that is heavily influenced by emotions and liquidity. When enough investors become fearful, panic sets in... And everyone starts to sell.

But there's another major reason that the bond market reacts violently in times of a crisis...

You see, most corporate bonds are not held by individual investors. Instead, they're held by big institutions like mutual funds, pension funds, and insurance companies. These institutions have policies that require their holdings to be rated "investment grade."

Credit-ratings agencies assign a rating to most bonds, depending on how safe they believe the bonds to be. Ratings range from "AAA" (safest) all the way down to "CCC" (riskiest).

The lowest rung on the "investment grade" ladder is "BBB." When a corporate bond with a "BBB" rating gets downgraded, it gets moved into "noninvestment grade" or "junk" status ("BB" or lower). When that happens, big institutional investors are forced to sell their positions.

As debt instruments, bonds are ahead of equities in a bankruptcy. So, unlike stocks, bonds aren't worthless in a bankruptcy. On average, bondholders have historically recovered about $0.40 on the dollar in bankruptcies.