Bonds 101

What is a bond?

Earlier we talked about how corporations are a legal entity who can buy buildings, desks, chairs and computers and can hire or fire employees. Well they can also borrow money. A bond is essentially an IOU from a corporation. When you “buy” a bond you are loaning an organization money and they promises to pay you interest at a rate called “yield”, for a specific period of time. At some future date, called the “maturity date”, they return your initial loan. Not all bonds are issued by corporations, some are issued by government agencies. Some government bonds make interest payments that are lower yield but tax-free. This can be particularly advantageous to earners in higher tax brackets.

Generally, bonds are considered lower risk than stocks. If you keep the bond until maturity the only way to lose money is if the entity that issued them defaults on their payments. If you sell a bond on the “bond market” before its maturity, you can make or lose money. If interest rates on new bonds are higher than yours, people will pay you less.  Likewise, if interest rates on new bonds are lower than yours, people will pay you a premium. (Don’t forget the broker’s commission.)

The interest rate paid by a bond is partially determined by the financially stability of the issuer. Bonds are rated AAA for the highest credit worthy issuers, and then continue to AA, A, BBB, etc.  The lower the rating, the higher the interest paid. The lowest credit worthy bonds, those rated BBB or less, are called “Junk Bonds” because there is a reasonable chance the company might not be able to make payments. Brokers prefer the term “High Yield” because these bonds pay higher rates of return, but don’t be fooled – they are still junk. You can lose all your money. Just ask holders of “Toys R Us” bonds how those high yield interest payments are going.