While many people are familiar with the stock market, few fully understand the bond markets. This is to be expected if you consider the size and complexity of each of those markets. As of the first quarter of 2015, the U.S. Equity Market totaled $18.7 trillion, while the U.S. Bond Market totaled over $39 trillion making it more than twice as large. In addition to size, bonds are arguably more complex instruments when you consider all the many ways in which they can be issued. Unfortunately, the complexity of the bond market has caused many individuals to write them off. In response, we thought we’d take some time to break down and familiarize our readers with the structure and financial nature of bonds with the hopes of easing fears about the unknown.
Bonds are like loans. When a company issues a bond they are in effect taking out a loan from the bond buyer that they will pay interest on over the course of the bond’s life. When you buy a bond, you are making a loan. The riskier the loan is, the higher the rate of interest will be.
The bond market is often referred to as the fixed income market (similar to how stocks are often referred to as equities). Like the name infers, bonds provide fixed income which is why they’re often associated with conservative investing. When an individual investor is looking for a fixed stream of income it usually makes more sense for them to invest in bonds than in stocks because bonds are created to provide a stream of constant income in the form of coupon payments. You can think of coupon payments like interest payments. Consider a mortgage: in a mortgage, you make monthly payments of principal and interest. Owning a bond is similar to owning someone’s mortgage in that you receive a fixed payment of interest on a regular basis. The main difference between a bond and mortgage is that instead of also slowly receiving principal payments during the life of the bond (like you would a mortgage) you receive one large payment of principle all at once at the end. Some bonds are issued at a discount, which creates an additional opportunity for returns.
Returning to our mortgage example: consider a $500,000 mortgage that you can buy for $490,000. Not only will you receive interest on the mortgage, but you will also be paid back $500,000 in principal even though you only lent the person $490,000. This is what happens when a bond is issued at a discount.
Bonds are usually less volatile than stocks because they maintain seniority in the capital structure. This means that if a company declares bankruptcy, bondholders are paid back first whereas equity holders receive their money last (if there is any left at that point). This means that bondholders are more likely to get their money back in the event of a company going bankrupt, which is why they are considered less risky than equities.
Example: How a Bond Works
Let’s wrap up our explanation of bonds with a simple example. Let’s say you buy a 4 year bond from Coke for $950. You have in effect made a loan to Coke for $1,000. Why $1,000 and not $950? Corporate bonds have what is called a par value of $1,000 meaning the bondholder always receives $1,000 in principle per bond at the end. By buying the bond for $950 you are buying the bond at a discount (think of it as buying a $1,000 tv for $950 – what a deal!). The bond has a coupon payment (interest payment) of 4% per year. This is the interest you are receiving on the loan you made and it is calculated based on the par value so every year you receive an interest payment of $40 ($1,000 x 4% = $40). At the end of the bond’s life you receive one final interest payment of $40 plus the par value of the bond ($1,000) for a total of $1,040). Your return on the bond is the total of the interest payments plus the $50 you made by buying the bond at a discount ($1,000 par - $950 purchase price).
If you’d like to learn more about how bonds work or have any questions regarding this article or any of our other articles, please don’t hesitate to give us a call.
Sifma. (May 2015). US Bond Market Trading Volume. Retrieved from: http://www.sifma.org/research/statistics.aspx
Quandle (March 2015). Stock Market Capitalization By Country. Retrieved from: https://www.quandl.com/collections/economics/stock-market-capitalization-by-country.