What Is A Bond?
Bonds are possibly the oldest financial instrument in history. That’s because a bond is a loan, and lending has been around for thousands of years.
There are trillions (yes, Trillions) of dollars worth of bonds outstanding around the globe. That’s a lot of borrowing and lending! The global bond market is much larger than the stock market, though it receives much less fanfare.
As an investor, as a purchaser of bonds, you are acting as a lender. The company or government issuing the bonds is the borrower. When the Federal government borrows money, we call them Treasury bonds. When a local government borrows money, we call them Municipal bonds (Munis for short). When a business borrows money, we call them Corporate bonds.
When you buy a bond (i.e. make a loan), you will earn interest on the money you’ve lended. The amount of interest you earn will be based predominantly on the riskiness of the borrower. When you buy a Treasury bond, you’re virtually guaranteed to get your money back from Uncle Sam, so the interest rate you earn will be very low. In fact, the interest rate earned on Treasury bonds is called the Risk Free Rate. When you buy a Corporate bond, the risk is a bit higher, so you’ll earn a higher interest rate. The spread between the expected earnings on a higher-risk investment and a lower-risk investment is called the Risk Premium.
The return on investment over the life of the bond is fixed, so bonds are also called fixed income investments. Compared to stocks, whose returns are determined by its increases in value (capital appreciation), the value of bonds remains relatively stable. When you invest in bonds, your return doesn’t come from capital appreciation; it comes from interest (there is some nuance to the previous statement – there are situations in which your bonds can appreciate in value – however, this subject is a bit more complicated and will be saved for a later date). In fact, these interest payments are contractually guaranteed. There are consequences if a business defaults on its loan (if they fail to make interest payments).
Because interest payments are contractually guaranteed, your investment return can be determined with a high degree of certainty. This is different than stocks, whose returns are based on the change in fortune of the issuing company. Because your investment return is more certain, there is less risk. Because there is less risk, your investment returns will be lower than stocks. Always remember:
The greater the risk, the greater the potential return.
Remember, when you buy a bond you are making a loan. As a lender, your investment returns will come from interest payments, not from capital appreciation. Bond values tend to be more stable than stock values. There is less risk when investing in bonds versus stocks, therefore expected returns are lower, even though they are more stable.
Do you have a question, or would like me to cover a particular topic, feel free to leave a comment below!