Understanding How Lending Money Can Produce Income, Reduce Certain Risks, and Add Stability to a Portfolio
By the end of this lesson, you’ll understand:
Stocks allow you to become an owner.
Bonds allow you to become a lender.
When you purchase a bond, you are generally lending money to a government, company, municipality, or other organization.
In exchange, the issuer promises to:
Bonds are often described as more conservative than stocks.
That can be true in certain situations, but bonds are not risk-free.
A bond can:
Understanding bonds can help you build a portfolio that does not depend entirely on stock-market growth.
A bond is a debt security.
When an organization issues a bond, it is borrowing money from investors.
The issuer might use that money to:
The investor provides capital.
The issuer promises repayment according to the bond’s terms.
This relationship makes bondholders creditors rather than owners.
Stocks and bonds represent different relationships with an organization.
A stockholder:
A bondholder:
Bondholders generally have more predictable contractual payments.
Stockholders generally have greater potential to participate in business growth.
Both can lose money.
Face value, also called par value or principal, is the amount the issuer promises to repay at maturity.
Many bonds use a face value of $1,000, although denominations vary.
The bond’s current market price may be higher or lower than its face value.
The coupon rate is the annual interest rate established by the bond’s terms.
Suppose a bond has:
The annual coupon interest is:
$1,000 × 5% = $50
If the bond pays interest twice per year, the investor may receive two payments of $25.
Payment schedules and terms vary.
The maturity date is when the issuer is scheduled to repay the bond’s face value.
A bond may mature in:
Maturity affects:
Longer-term bonds generally experience greater price changes when interest rates move, all else being equal.
A bond’s market price is what investors are currently willing to pay for it.
A bond may trade:
A $1,000 bond might trade for $980, $1,000, or $1,040 depending on interest rates, credit quality, remaining maturity, and market demand.
Yield measures the income or return associated with a bond relative to its price.
Different yield calculations answer different questions.
The coupon rate is based on face value.
A $1,000 bond with a 5% coupon pays $50 annually according to its terms, regardless of whether you purchased the bond for $950 or $1,050.
Current yield compares the annual coupon payment with the bond’s current market price.
The formula is:
Suppose:
Current yield:
$50 ÷ $950 = approximately 5.26%
If the market price rises to $1,050:
$50 ÷ $1,050 = approximately 4.76%
FINRA explains that current yield changes when the bond’s market price changes, even though a fixed coupon rate generally does not. FINRA provides additional guidance on bond yields and returns.
Yield to maturity estimates the bond’s annualized return if:
Yield to maturity considers:
Yield to maturity is often more informative than coupon rate alone.
It is still an estimate based on assumptions, not a guaranteed return.
A bond’s contractual payments may remain fixed, but its market value can change every day.
Prices may respond to:
One of the most important relationships in bond investing is the connection between interest rates and prices.
Bond prices and market interest rates generally move in opposite directions.
Suppose you own a $1,000 bond paying 4% interest.
It provides $40 of annual coupon income.
Later, newly issued bonds of similar quality and maturity begin paying 6%.
A new investor can receive $60 annually from a new $1,000 bond.
Your older bond paying $40 is now less attractive.
To persuade someone to purchase it, its market price may need to fall.
The reverse can also happen.
If new bonds pay only 3%, your existing 4% bond may become more attractive and rise in market value.
The SEC emphasizes that fixed-rate bond prices generally fall when market rates rise, with longer maturities and lower coupons often experiencing greater sensitivity. Investor.gov explains interest-rate risk in bonds.
If you hold an individual bond until maturity and the issuer fulfills its obligations, you generally receive:
Short-term market price changes may not affect the amount paid at maturity.
However, several risks remain:
Holding to maturity can reduce the importance of temporary price movement.
It does not eliminate bond risk.
Duration is a measure used to estimate how sensitive a bond or bond fund may be to changes in interest rates.
In general:
A fund with a duration of approximately seven years may experience a price decline of roughly 7% if market interest rates rise by one percentage point, all else being equal.
This is an estimate, not a guarantee.
Duration does not measure every type of risk.
A low-duration bond can still experience:
Duration helps explain interest-rate exposure, not total safety.
Treasury securities are issued by the U.S. Department of the Treasury.
They include:
Treasury securities are backed by the U.S. government and are generally considered to have very low default risk.
However, they still face:
Treasury interest is subject to federal income tax but exempt from state and local income taxes under current federal rules. The IRS explains the taxation of Treasury interest.
Treasury Inflation-Protected Securities, commonly called TIPS, are designed to provide protection against inflation.
Their principal value adjusts based on an inflation measure.
Interest payments are calculated using the adjusted principal.
TIPS can help address inflation risk, but they can still:
Inflation protection does not mean price stability.
Savings bonds are nonmarketable Treasury securities designed for individual savers.
Unlike marketable Treasury securities, savings bonds generally cannot be traded in the secondary market.
Their redemption rules, holding periods, interest calculations, and tax treatment differ from ordinary marketable bonds.
Investors should review current TreasuryDirect rules before purchasing or redeeming them.
Municipal bonds are issued by:
Municipalities may use bond proceeds to finance:
Interest from certain municipal bonds may be exempt from federal income tax.
It may also receive favorable state or local tax treatment, depending on the bond and the investor’s residence.
Not every municipal bond receives the same tax treatment. Some municipal-bond interest may also affect alternative minimum tax calculations or other tax matters.
Tax benefits do not eliminate credit risk.
A financially troubled municipality can still default.
Corporate bonds are issued by businesses.
Companies may borrow to:
Corporate bonds usually offer higher yields than similar-maturity Treasury securities because investors accept additional credit risk.
The company could:
Corporate bonds range from relatively high-quality securities to highly speculative debt.
Agency bonds are issued or supported by certain government-related organizations.
Their risks and government backing vary.
Some may have an explicit federal guarantee.
Others do not.
Investors should not assume every security associated with a government-sponsored organization carries the same protection as a Treasury security.
International bonds may be issued by:
They may introduce additional risks, including:
A high yield may be compensation for substantial risk.
Credit-rating agencies evaluate the ability of issuers to meet their debt obligations.
Bonds are often grouped into:
These bonds receive ratings indicating relatively lower credit risk.
Lower credit risk does not mean no credit risk.
Ratings can change, and an issuer can still default.
High-yield bonds receive lower credit ratings and involve greater perceived default risk.
They are sometimes called junk bonds.
Issuers generally must offer higher yields to attract investors.
That higher yield is not free additional return.
It is compensation for accepting greater risk.
Investor.gov notes that high-yield bonds typically offer more income because investors perceive a greater possibility of default. Review Investor.gov’s description of high-yield bonds.
Credit ratings may help investors evaluate an issuer’s ability to make payments.
However, ratings:
A bond can decline if its rating is downgraded.
A downgrade suggests that the issuer’s ability to repay may have weakened.
Investors should consider:
Credit risk is the possibility that the issuer will fail to make interest or principal payments.
FINRA identifies credit or default risk as one of the central risks facing bond investors. FINRA’s bond guide explains credit, call, reinvestment, and other bond risks.
Interest-rate risk is the possibility that a bond’s market price will decline when market rates rise.
Longer-term and lower-coupon bonds are generally more sensitive.
Inflation can reduce the purchasing power of fixed payments.
If a bond pays 3% while inflation averages 4%, the investor’s purchasing power may decline even while receiving every promised payment.
Reinvestment risk is the possibility that interest payments or returned principal will need to be reinvested at a lower rate.
This often becomes more noticeable when interest rates are falling.
A callable bond allows the issuer to repay the bond before its scheduled maturity under stated conditions.
An issuer may call a bond when interest rates fall, much like a homeowner refinancing a mortgage.
The investor receives the call price but loses future interest payments and may have to reinvest at a lower yield.
FINRA advises investors to review callable-bond terms carefully because many bonds can be redeemed before their original maturity. FINRA explains callable bonds and their risks.
Liquidity risk is the possibility that you cannot sell a bond quickly at a fair price.
Some bonds trade infrequently.
A bond’s displayed value may differ from the price a buyer is actually willing to pay.
A bond’s price may fall if a rating agency lowers the issuer’s credit rating.
The downgrade may also make the bond harder to sell.
A bond denominated in another currency can gain or lose value as exchange rates change.
You can receive every promised payment in the foreign currency and still lose money after converting it into U.S. dollars.
An issuer’s ability to repay may be affected by:
A zero-coupon bond does not make regular coupon payments.
Instead, the investor typically purchases it for less than face value and receives the face value at maturity if the issuer pays as promised.
For example:
The $200 difference represents part of the investor’s return.
Zero-coupon bonds can be especially sensitive to interest-rate changes.
They may also create taxable income before the investor receives cash, depending on the bond and account.
Investor.gov explains that zero-coupon bonds make a larger payment at maturity rather than periodic coupon payments. Investor.gov provides an introduction to zero-coupon corporate bonds.
Investors can obtain bond exposure through individual securities or pooled funds.
An individual bond has:
If held to maturity and paid as promised, the investor generally receives the face value.
Building a diversified portfolio of individual bonds may require more money, research, and monitoring.
A bond fund may hold dozens, hundreds, or thousands of bonds.
Potential benefits include:
However, most bond funds do not have one maturity date at which the investor’s original principal is automatically returned.
The fund continually buys, sells, and replaces bonds.
Its share price can rise or fall.
Selling a bond fund after a market decline can produce a loss.
A bond ladder is a collection of bonds with different maturity dates.
For example, an investor might own bonds maturing in:
As each bond matures, the investor may:
A ladder may help manage:
It does not eliminate default, inflation, call, or market risk.
Each bond must still be evaluated.
Before purchasing an individual bond, review:
Who owes you the money?
How likely is the issuer to make the promised payments?
When is the principal scheduled to be returned?
How much interest does the bond promise?
Are you buying at a premium, discount, or par?
What is the estimated annualized return if the bond is held to maturity and payments occur as expected?
Can the issuer repay the bond early?
When and at what price?
How easily can the bond be sold?
What spread or markup might apply?
Is the interest federally taxable, tax-exempt, or subject to special rules?
Is the bond intended to provide:
A higher yield should always lead to another question:
Bonds can support stability and income.
They work best when selected as part of a complete investment plan rather than as a response to fear or a tempting yield.
Meet Priya.
Priya has a long-term investment portfolio made mostly of stock funds.
She wants to reduce some of the portfolio’s dependence on stock-market performance.
She considers a diversified bond fund that holds:
The fund has:
Priya invests $20,000.
The approximate annual expense represented by the expense ratio is:
$20,000 × 0.10% = $20
Later, market interest rates rise.
The fund’s share price declines because its older bonds are less attractive than newly issued bonds paying higher rates.
Priya is disappointed, but she understands:
She reviews the investment as part of her total asset allocation instead of judging it by one year’s price movement.
The payment terms may be fixed, but the bond’s market price can change.
A high coupon does not automatically mean a high return.
Purchase price, maturity, call features, credit quality, and yield all matter.
Even a high-quality bond can decline when interest rates rise.
An unusually high yield may indicate unusually high default, liquidity, call, or market risk.
Most bond funds do not have one maturity date.
Their share prices continually change.
A high-coupon bond may be repaid early, forcing the investor to reinvest at lower rates.
Bonds cannot lose money.
Bond prices can decline, and issuers can default.
The highest-yielding bond is the best bond.
Higher yield often reflects higher risk.
A bond paying 5% will always earn exactly 5%.
Your return depends on purchase price, reinvestment, holding period, issuer payments, taxes, and whether the bond is called or sold early.
Treasury securities have no risk.
They have very low default risk but still face interest-rate, inflation, reinvestment, and market-price risk.
Bond funds work exactly like individual bonds.
An individual bond has a stated maturity. Most bond funds continually replace bonds and do not promise to return your original investment on a specific date.
Municipal bonds are always tax-free.
Tax treatment depends on the bond and the investor’s circumstances.
High-quality bonds are generally less volatile than stocks, but risk varies widely.
A speculative corporate bond can be riskier than a short-term Treasury security.
“Bond” is a broad category, not a safety rating.
Many marketable bonds can be sold in the secondary market.
The sale price may be above or below what you paid, and liquidity may be limited.
Savings bonds and certain other securities have different redemption rules.
The fund’s holdings may have fallen in market value because interest rates increased, credit conditions weakened, or investors demanded higher yields.
Income does not prevent price declines.
Individual bonds can provide specific maturities and cash flows.
Bond funds can provide easier diversification and professional management.
The better choice depends on your goals, resources, time horizon, tax situation, and ability to evaluate bonds.
The issuer may miss interest or principal payments.
Bondholders may recover some money through restructuring, bankruptcy, collateral, or other legal processes, but full recovery is not guaranteed.
Only if the issuer makes them as promised.
The strength of that promise depends on the issuer, bond terms, and any applicable backing or insurance.
No.
Ratings can be raised or lowered as the issuer’s financial condition changes.
Traditional fixed-rate bonds may lose purchasing power during high inflation.
TIPS and certain other investments are designed to provide some inflation protection, but they carry their own risks.
Choose one bond or bond fund and complete a risk review without purchasing it.
Identify:
The issuer or types of issuers
The maturity or average maturity
The coupon or yield
The credit quality
The duration, if it is a fund
Whether the bonds are callable
The tax treatment
The main reason the investment belongs in a portfolio
Then answer:
What risk explains the yield this investment is offering?
Yield is never meaningful without understanding the risk required to earn it.
Bonds may pay interest.
Stocks and stock funds may pay dividends.
In the next lesson, you will learn:
Understanding dividends will help you evaluate investment income without confusing a cash payment with a guaranteed profit.
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