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How exactly do bonds work?

Aug 25th, 2021 • Lisa W.

If you are an investor — and if you have a retirement account, you are! —  there is a pretty good chance that your money is invested in a mix of stocks and bonds. Likely you are pretty comfortable with the basic mechanics of what a stock is; a share is a small ownership piece of a company. When the price goes up, you’re happy and when it goes down, you’re sad. It is pretty intuitive. But do you understand how the bond portion of your portfolio works? Do you even know why it is there?

Stepping back, when you chose your investments (perhaps through a target date fund, geared to the year that you expect to retire) you likely chose to hold a percentage of your investment in bonds. The reason is that, historically, bonds experience fewer wild swings in price than stocks. As well, it is often the case that when stocks perform relatively poorly in the market, bonds gain in value. Including bonds as part of your investment strategy can make the overall return of your portfolio more stable from year to year.

But what, exactly, is a bond? In the simplest terms, when you buy a bond you are lending money to someone…the US government, for example, when you buy a treasury bond. But it could be a loan to a state or local government, or to a private company. And like any loan, there is a possibility that the lender won’t get paid back. For that reason, bonds have a rating; “AAA” meaning that there is very, very little risk that you won’t be paid back (US treasury bonds are considered “risk free”), down to the letter “C” and even worse, meaning that there is a pretty good chance that the borrower will not be able to repay. This is called “credit risk.” Of course, just as with any consumer loan, the less creditworthy the borrower, the higher the interest rate. 

The bond market acts in a way that many people find strange, and yet for investors it is important to understand a bit of the basic mechanics. When interest rates in the overall economy go up, the value of my bond goes down. Huh.

Think about it…If I buy a bond, I am getting paid back in two ways. First, every so often (perhaps twice a year), I receive an interest payment from the borrower (the coupon, in bond speak). And then, when the bond matures (i.e. the loan is due to be paid back), I get back the amount that I loaned out (the principal). But along the way, I may decide that I no longer want to own the bond and so I sell it to another investor. If that interest payment was 5%, but now there are newer just issued bonds available in the market that pay 6% in interest, I need to sell my “old” bond at a lower price so that someone will take it off of my hands. 

Now, this change in price may be a lot or a little…it depends of course on the difference in interest rates, but also it depends on how “long” the bond is. Will it mature in just a year, or even less time than that? Or will it mature 10 or even 30 years from now? If it will be a long time until maturity, the change in price could be quite dramatic…the new owner of the bond will have to think about how interest rates will affect the value of his or her bond over many years. (That’s called “interest rate risk.”) But if the bond is going to mature very soon, the risk that new bonds offering better, higher interest rates will become available before my “old” bond matures is not that great.

So where does that leave us? If you own bonds via a bond index mutual fund, you will see that the price of a share of the mutual fund will go up when interest rates in the economy go down, and go down when interest rates go up. If this mutual fund consists of bonds that mature fairly soon (perhaps in just 2 or 3 years), then the price change will likely be quite small. If the mutual fund consists of “long” bonds (maturing 30 years from now), the price change will be more dramatic. 

But bear in mind that while all of this is going on in the market, you are collecting periodic interest payments. These come to you as the dividend payments from the bond mutual fund. This is one of the reasons that high quality bonds from creditworthy borrowers are generally less risky than stocks; you benefit immediately from a stream of payments while you own the bond, and if market interest rates change in your favor, you have the possibility of selling the bond (or the mutual fund share) at a profit.

Let’s review:

  • When you buy a bond (or a share in a bond mutual fund), you have two kinds of risk. The risk that the borrower will not pay you back (credit risk) and the risk that interest rates in the economy will go up, making your bond less valuable (interest rate risk).
  • You can largely avoid credit risk by buying very highly rated bonds.
  • You reduce interest rate risk when you buy bonds that have shorter maturities.
  • Because of interest rate risk, the price of the bond will go down when market interest rates go up. And vice versa: the price of the bond will go up as interest rates fall.
  • When you own a bond, your “total return” consists of the periodic payment of interest plus any change (up or down) in the price of the bond.
  • The ups and downs of highly rated bond prices are usually less dramatic than the ups and downs of stock prices. And much of the time, the prices of bonds react differently to changes in the economy than the prices of stocks.

With these fundamentals in mind, you can more confidently make a decision about the role of bonds in your investment portfolio.

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