Bonds

A Bond is essentially a loan made by an investor to a borrower. Think of it as a formal IOU on a grand scale. When you buy a bond, you are lending money to an entity, known as the Issuer, which could be a corporation or a government. In return for your money, the issuer promises two things: first, to pay you periodic interest payments, called the Coupon, over a set period; second, to repay the original amount of the loan, called the Par Value (or Face Value), on a specific future date, known as the Maturity Date. This structure makes bonds a form of Debt financing for the issuer and a fixed-income investment for the lender. Unlike stocks, which represent ownership in a company, bonds represent a creditor's stake. This distinction is crucial; as a bondholder, you don't own a piece of the company, but you are first in line to get paid back if the company runs into financial trouble. This senior claim makes bonds generally less risky than stocks, offering a more predictable, though typically lower, return.

Imagine your friend, Bob, wants to start a business and needs to borrow $1,000. You agree to lend him the money. Bob gives you a fancy IOU certificate stating that he will pay you back the full $1,000 in exactly five years. As a thank you for the loan, he also promises to pay you $50 every year until he pays you back. In this scenario, you've essentially bought a bond.

• You are the bondholder (the investor).
• Bob is the issuer (the borrower).
• The $1,000 loan is the par value of the bond.
• The five-year term is the bond's maturity.
• The $50 annual payment is the coupon payment. The Coupon Rate is the annual payment divided by the par value: $50 / $1,000 = 5%.

You get a steady stream of income ($50 a year) and your original investment back at the end, assuming Bob's business doesn't go bust!

Every bond is defined by a few core components that you should always check before buying.

This is the amount the bond will be worth at its maturity. It's the principal of the loan that the issuer repays to the bondholder. While bonds can be traded on the open market at prices above or below par (at a premium or a discount), the par value is the fixed sum you'll receive when the bond “comes due.” For most Corporate Bonds, this is typically $1,000 or €1,000.

This is the interest rate the issuer agrees to pay on the bond's par value. If a $1,000 bond has a 5% coupon rate, it will pay $50 in interest per year. This payment is usually made semi-annually (e.g., $25 every six months). Some bonds, called Zero-Coupon Bonds, don't pay any coupon at all. Instead, they are sold at a deep discount to their par value, and the investor's return is the difference between the purchase price and the par value received at maturity.

This is the date when the issuer has to repay the bond's par value. Maturities can be:

• Short-term: Less than three years.
• Medium-term: Between three and ten years.
• Long-term: More than ten years, sometimes as long as 30 years or more.

Bonds are most easily categorized by who is doing the borrowing.

Issued by national governments, these are generally considered the safest bonds because governments have the power to tax (and in some cases, print money) to repay their debts. The risk of Default is extremely low.

• In the U.S., these are Treasury Securities (T-Bills, T-Notes, and T-Bonds), widely seen as a global benchmark for a “risk-free” investment.
• In Europe, notable examples include German Bunds and British Gilts.

Issued by companies to raise money for everything from new research to building factories. They are riskier than government bonds because companies can go bankrupt. To compensate for this added risk, corporate bonds almost always offer a higher interest rate, or Yield, than government bonds of the same maturity.

Issued by states, cities, counties, or other local authorities to fund public projects like schools, bridges, and hospitals. Their most attractive feature, particularly in the United States, is that the interest income they generate is often exempt from federal income tax, and sometimes state and local taxes as well, making them especially appealing to investors in high tax brackets.

From a Value Investing perspective, understanding risk is paramount. With bonds, two risks stand out.

This is the most straightforward risk: the chance that the issuer will fail to make its promised payments. To help investors gauge this risk, independent agencies like Moody's, Standard & Poor's, and Fitch Ratings provide a Credit Rating for most issuers.

• Investment-Grade: Ratings from AAA (the highest quality) down to BBB- are considered “investment grade,” implying a low risk of default.
• High-Yield (“Junk”): Ratings below BBB- are considered speculative. These High-Yield Bonds (often called Junk Bonds) must offer much higher coupon rates to lure investors into taking on the significant risk. A value investor treats these with extreme caution, as the high yield may not be enough to compensate for the potential loss of the entire principal.

This risk is more subtle. It's the danger that a rise in market interest rates will cause the value of your existing bond to fall. This only matters if you plan to sell your bond before its maturity date. It works like a see-saw:

• When market interest rates RISE, newly issued bonds will have higher coupons. This makes your older, lower-coupon bond less attractive, so its market price will FALL.
• When market interest rates FALL, your older, higher-coupon bond becomes a hot commodity, and its market price will RISE.

The longer a bond's maturity, the more sensitive its price is to changes in interest rates.

Benjamin Graham, the father of value investing, viewed bonds as a cornerstone of a conservative portfolio. Their main job is not to make you rich, but to keep you from becoming poor.

• Capital Preservation and Income: For the value investor, high-quality bonds are primarily a defensive tool. They provide a predictable income stream and are generally less volatile than stocks, helping to stabilize a portfolio during stock market downturns.
• Calculate Your True Return: Don't just look at the coupon rate. A savvy investor calculates the Yield to Maturity (YTM), which reflects the total return you'll receive if you hold the bond to maturity, taking into account its current market price. This is the best measure of a bond's value to you.
• Beware of Inflation: A bond yielding 3% is no bargain if Inflation is running at 4%. In that case, you are losing purchasing power. A value investor always considers the real return (the yield after subtracting the inflation rate) when evaluating a bond.
• Safety First: The core principle is to lend money only to entities with an extremely high probability of paying you back. For most investors, this means sticking to high-quality government and corporate bonds. Chasing the high yields of junk bonds is a speculator's game, not a prudent investor's. As with any investment, the goal is not to find a good company, but a good investment at a fair price.