The Basics of Bonds

Bonds can be a powerful tool that you’ll want to consider adding to your portfolio.

A great way to describe a bond is it’s similar to postdated check that is going to pay out a certain amount by a specified date. Most bonds usually come in a $10,000 increment. 

Now, when purchasing a bond, you might notice that it doesn’t mature for several years. 

It could be a ten year bond, a twenty year bond, or even a thirty year bond. Now why on earth would someone buy a bond if it doesn’t even mature for thirty years? The answer is simple—oftentimes, the bond comes with a coupon. A coupon states the annual percentage rate, which will be paid to the bond holder semiannually.

The Concerns of the Bond Holder

What are the concerns with owning bonds? Number one, I’m always concerned if the company defaults. If this happens, they will miss a coupon payment.

It’s like when someone misses a credit card payment (or any sort of obligation where they owe somebody money and they miss that payment), then what happens? They also go into default. Now, can that person (or business) come out of default? Yes, they can. But what happens to their credit score or their rating? Well, it’s a big black eye, so they don’t want to ever miss those payments and go into default.

Another concern is if they go bankrupt, meaning that they close their doors, and are no longer operating as a business. When they start going through the bankruptcy proceedings here in the United States, we have the bankruptcy laws and there’s a pecking order on who gets paid off first.

One nice thing about being a bond holder (versus a stock holder) is that they are higher up on the pecking order. Typically, when a company defaults, the bond holders collect ~50% of the maturity value. So rather than receiving $10,000, they may receive $5,000. The fortunate thing is they’ve usually also been able to collect some coupons along the way.

The Diversified Portfolio

Another thing that is important when it comes to purchasing bonds is that the portfolio is properly diversified.

Avoid putting all your money inside one particular company or bond. You’ll likely want to make sure you diversify those bonds out, due to the risk of default or bankruptcy. It’s also good to ladder them, so that they have different maturity dates.

The Rise and Fall of Interest Rates

Next, I’d like to talk about interest rates and bonds. The fair market value (FMV)—what you’re paying or what you could sell your bond for on the open market—works inversely to interest rates.