What Are Bonds? | Finances | MD&D #29

Evidence based insights into physician compensation, RVUs, contracts, healthcare economics, and personal finances. For residents, fellows, and early-career attendings.

Life and Finances, in Medicine.

A bond is essentially a loan. Although stocks get most of the attention when people talk about investing, bonds are a major part of the financial market. Understanding bonds is very important because they behave very differently from stocks.

When you buy a bond, you are basically lending money to a government, a municipality, or a company. In exchange, the borrower agrees to pay you interest and eventually return your principal.

Suppose a company issues a $1,000 bond paying 5% interest for ten years. You lend the company $1,000 by buying its bond. The company pays you $50 per year in interest, and at the end of ten years, the bond's maturity, assuming the company remains financially able to pay its obligations, it returns your $1,000. That sounds simple.

How Does a Bond Work?

When a bond is issued, it typically has a face value, an interest payment, and a maturity date.

In our example, the face value is $1,000, the interest rate is 5%, and the maturity is ten years. The $50 annual payment is based on that 5% interest rate. The interest payment promised by the bond is generally fixed. But once bonds begin trading in the market, their prices can move up and down. This is where bonds become more exciting.

Why Do Bond Prices Fall When Interest Rates Rise?

If newly issued bonds begin paying higher interest rates, an older bond paying a lower rate becomes less attractive. Its market price will usually fall. The opposite is also true. If newly issued bonds begin paying lower rates, an older bond with a higher interest payment becomes more attractive, and its market price may rise.

Changes in interest rates are one of the main reasons bond prices move. Inflation, the financial strength of the borrower (i.e. the company or government), and the amount of time remaining until maturity can also affect a bond's value.

This creates one of the fundamental relationships in investing: Bond prices and bond yields move in opposite directions. When bond prices fall, their yields rise. When bond prices rise, their yields fall.

Two concepts worth remembering: The bond's coupon is the contractual interest the company or government agreed to pay you. Yield is the return you receive relative to the price you paid for the bond.

What Are the Main Types of Bonds?

Bonds differ in their level of risk and in who is borrowing the money. Here are some of the most common ones:

1. U.S. Treasury securities are issued by the federal government and are generally viewed as having very low credit risk. Treasury securities are commonly used as a benchmark for low-risk interest rates in financial markets.

2. Municipal bonds are issued by states, cities, and other governmental entities. Interest from many municipal bonds may be exempt from federal income tax and, depending on the bond and where you live, potentially state or local taxes as well.

3. Corporate bonds are issued by companies. Because companies may have a greater chance of financial difficulty or default, corporate bonds usually need to offer investors higher yields than comparable Treasury securities. In general, investors get a higher potential return because they are taking a greater credit risk.

Why Does Bond Maturity Matter?

Bond maturity is the time when you should expect the return the money you invested. A bond may mature in a few months, several years, or several decades. Longer-term bonds generally react more dramatically to changes in interest rates. If rates rise sharply, the price of a long-term bond can fall considerably, even when the government, municipality, or company continues making every scheduled payment. This sensitivity of bond prices to changes in interest rates is known as interest-rate risk.

This surprises many investors. Bonds are considered less volatile than stocks, but that does not mean they cannot lose value.

What Risks Do Bonds Have?

There are several risks to understand when investing in bonds.

One is interest-rate risk. If interest rates rise, the market value of an existing bond may fall, like I mentioned above.

Another is credit risk, sometimes called default risk. This is the possibility that the government, municipality, or company that borrowed the money from you, may have difficulty paying you interests or returning the principal.

The amount of risk varies significantly from one bond to another. A U.S. Treasury security and a bond issued by a financially distressed corporation are both bonds, but they carry very different levels of credit risk.

Why Do Investors Own Bonds?

Why own them, then? Bonds may provide income, diversification, and stability. Stocks represent ownership in businesses and offer greater long-term growth potential, but they can also experience significant changes in value. Bonds are different. They are often seen as buffers in investors' portfolios. They can behave differently from stocks, potentially reducing the overall volatility of your portfolio.

Their role often becomes more important as investors approach retirement and has less time to recover from a major stock-market decline. And it is at that same stage, that investors may also begin withdrawing money from their portfolios, making large fluctuations in value more significant.

But not all bonds are created equal. Before buying a bond or bond fund, research who you are lending money to, how long your money is exposed, what return you are receiving, and what risks you are taking.

Stocks vs. Bonds: Owner vs. Lender

The difference between them can be summarize this way: Stocks allow you to become an owner. Bonds allow you to become a lender. A well-designed portfolio may use both, but for very different reasons.

Bonds are not simply "safe investments." They carry their own risks, returns, and market behavior. For many investors, their value comes from providing income, diversification, and potentially reducing some of the volatility that comes with owning stocks. The key is understanding what you are buying.

1. A bond is a loan. When you buy a bond, you are lending money to a government, municipality, or company in exchange for interest payments and the eventual return of your principal.

2. Bond prices and interest rates move in opposite directions. When interest rates rise, existing bond prices generally fall. When rates fall, existing bond prices may rise.

3. Bonds can provide income and stability, but they still have risk. Interest-rate risk, credit risk, and maturity all affect how a bond may perform.

“Stocks allow you to become an owner. Bonds allow you to become a lender.”

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Life and Finances, in Medicine.