Bonds. We’ve all heard of them at some point. But most of us probably had to Google the term “bonds explained” to try to figure out what a bond actually is. Bonds can be a useful tool when investing. Especially if you are investing for either regular interest payments or want your investment to be relatively safe. So today, let me explain (1) what bonds are, (2) the types of bonds, and (3) what to look for in bonds. Let’s go!
(1) What Are Bonds?
Bonds are simply a loan that you (the investor) give to a government entity or to a corporation. Think of yourself as the bank and a government entity or corporation who is coming to you for a loan. It’s really as simple as that.
With a bond, you (the investor) loan money and that money is returned to you in the form of interest payments (called coupons) for a specified period of time. At the end of that time, your original loan amount (investment) is returned. Let’s look at an example.
The town of Winchestertonfieldville, Iowa wants to build a new hospital. They don’t have enough money to build it outright so they decide to issue a bond that looks like this:
- $10 million bond
- With 5% coupons
- For 10 years
The $10 million bond will be split up into smaller $1,000 bonds for individuals to purchase.
Babe Bennett decides she would like to invest in the bond. She decides that she will purchase a $1,000 bond for the new hospital. She gives the town her $1,000 and then she starts getting coupons (interest payments) for 10 years. At the end of the 10 years, she gets her original $1,000 investment back.
Babe’s cash flows look like this:
| Purchase Date: June 1, 2022 | ($1,000) |
| June 1, 2023 (Year 1): Coupon Payment | $50 |
| June 1, 2024 (Year 2): Coupon Payment | $50 |
| June 1, 2025 (Year 3): Coupon Payment | $50 |
| June 1, 2026 (Year 4): Coupon Payment | $50 |
| June 1, 2027 (Year 5): Coupon Payment | $50 |
| June 1, 2028 (Year 6): Coupon Payment | $50 |
| June 1, 2029 (Year 7): Coupon Payment | $50 |
| June 1, 2030 (Year 8): Coupon Payment | $50 |
| June 1, 2031 (Year 9): Coupon Payment | $50 |
| June 1, 2032 (Year 10): Coupon Payment | $50 |
| June1, 2032 Original Investment Return | $1,000 |
(2) Different Types of Bonds
There are two MAIN types of bonds:
- Government bonds
- Corporate bonds
Government bonds are used to fund items that the government needs. This can range from projects as large as building a new fleet of aircraft carriers for the military to as small as repairing the sidewalks in your subdivision.
Corporate bonds are bonds issued by (you guessed it) corporations. These bonds are used for a varying number of corporate tasks. These can range from paying down high-interest debt, cash flow shortages, business expansion, construction costs, etc.
Yes there are other types of bonds but they are outside the scope of this article. We’ll save GO and revenue bonds for another day.
(3) What To Look For In Bonds
There are two main items to look for in bonds:
- Creditworthiness
- Yield
Creditworthiness
Just like you and I have a credit score, bonds have something similar. It is simply called a credit rating. The higher credit rating a bond has, the safer it is for investors.
This is just like someone who has an 800 credit score is more likely to get a loan from a bank opposed to someone who has a 500 credit score. The person with an 800 credit score is much more likely to pay back their loan on time than the person with the 500 credit score.
Just like there are three credit bureaus that give each of us a credit score (Experian, TransUnion, and Equifax), there are three main credit agencies that give bonds ratings:
- Standard and Poor’s
- Moody’s
- Fitch
The higher the grade, the more safe that bond is. The lower the grade, the more likely the bond will default and you will lose your original investment.
Here are the ratings for each of the bond agencies:
| Moody’s | S&P | Fitch | Type of Bond | Investment/Junk |
| Aaa | AAA | AAA | Prime | Investment |
| Aa1 | AA+ | AA+ | High Grade | Investment |
| Aa2 | AA | AA | High Grade | Investment |
| Aa3 | AA- | AA- | High Grade | Investment |
| A1 | A+ | A+ | Upper Med Grade | Investment |
| A2 | A | A | Upper Med Grade | Investment |
| A3 | A- | A- | Upper Med Grade | Investment |
| Baa1 | BBB+ | BBB+ | Lower Med Grade | Investment |
| Baa2 | BBB | BBB | Lower Med Grade | Investment |
| Baa3 | BBB- | BBB- | Lower Med Grade | Investment |
| Ba1 | BB+ | BB+ | Speculative | Junk |
| Ba2 | BB | BB | Speculative | Junk |
| Ba3 | BB- | BB- | Speculative | Junk |
| B1 | B+ | B+ | Highly Speculative | Junk |
| B2 | B | B | Highly Speculative | Junk |
| B3 | B- | B- | Highly Speculative | Junk |
| Caa1 | CCC+ | CCC | Substantial Risk | Junk |
| Caa2 | CCC | Extremely Speculative | Junk | |
| Caa3 | CCC- | Default Imminent | Junk | |
| Ca | CC | CC | Default Imminent | Junk |
| C | C | Default Imminent | Junk | |
| / | D | D | In Default | Junk |
Yield
The second item to look for in bonds is yield. Yield is simply the coupon rate that you will be given in exchange for the government entity or corporation borrowing your money.
These rates change all of the time but in the time of writing this (2021), rates are near all-time lows.
The important thing to know when concerning the yield of a bond is that bond ratings and yields have an INVERSE relationship.
For example, if you are going to invest in a AAA bond your yield (coupon) might be 2%. But if you are going to invest in a BB bond your yield (coupon) might be 6%.
The reason for this is because the investor will want to be more highly compensated for investing in a less stable/riskier bond. If the bond is extremely stable (like an AAA) there is very little risk and therefore very little reward. The more risk that an investor takes, the more reward they will be given in the form of a higher yield.
Final Thoughts
Bonds certainly aren’t for everyone. Not everyone who has investable money should invest in bonds. They are typically considered a lower risk investment and therefore carry an overall lower return on investment. However, bonds certainly serve a good function in our society. In fact, if you pay local taxes, you are probably already invested in bonds through your tax dollars to pay for a high school, community center, roads and bridges, a hospital, etc.
I hope that this has helped give you one more piece of information to add to your financial literacy toolbelt!
If there is anything I can do for you, please don’t hesitate to let me know in the comments.
Until next time!
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