Broker Check

What is a bond?

January 24, 2023

Before we get into how bonds and stocks are different, let's explore what a bond is and how it works.

For example, you have a company that you'd like and they have bonds available. You want to invest $10,000 so you buy 10 bonds of ABC Company. Each bond starts as being valued at $1,000. ABC Company will pay 5% interest per year, as well as your initial investment after 10 years. Very generally, that's the makeup of a bond.

There are different types of bonds, for which you will be compensated differently for investing based on the risk/reward of the bond.

  1. Treasury Bonds - These types of bonds are issued by the U.S. Government or an agency of the U.S. Government. They're backed by the "full faith and credit" of the U.S. Government and are, therefore, as close to "no risk" as you can get. That said, governments can go bankrupt. Because it's such a low-risk investment, the potential return is low. This is an investment designed for safekeeping. It's not going to make you rich.
  2. Municipal Bonds - These bonds are issued by a state or local municipality. There are two types: revenue bonds and general obligation bonds (more below). General obligation bonds are generally considered safer because they're being paid by the municipality. In theory, municipalities can always increase taxes to help pay for their liabilities. Revenue bonds are reliant on the venue, or what have you, to pay the creditors.
    1. Revenue Bonds - Revenue bonds are used and designed for funding projects that will create an income source for whomever it was built for. Sometimes cities use this when they're putting up a new stadium for the local sports team. They'll chip in some money via revenue bonds, and will use the income generated at the stadium to help pay for the interest payments to the bondholders.
    2. General Obligation (GO) Bonds - GO bonds are used for non-revenue-generating government projects. New roads, bridges, etc.
  3. Corporate Bonds - Corporate bonds are issued by, you guessed it, corporations. These are not guaranteed and generally speaking, will have the highest interest rates available to bondholders. Corporations don't have taxpayers to lean on. Tomorrow, their company could go to zero. Conversely, if it's a big company that's been around and seemingly will be around for the foreseeable future. Their interest rates won't be as high as, say a company that got started 5 years ago but still isn't profitable. A company like that will have higher interest rates because it's riskier to invest in that company, and investors (bondholders in this case) need to be compensated for the risk they are taking.
    1. High-yield bonds - High-yield bonds are exactly what they sound like. Bonds with high yields. Companies that are newly established or companies that have gotten into some balance sheet trouble will issue these types of bonds.

Now that we have the basics covered, let's delve into investment-specific information.

A bond is a type of investment, like a stock. There are a couple of differences, however. Stocks are considered riskier than bonds because of liquidation priority and risk/reward dynamics. Let's break both down:

  • Liquidation priority - in the event that a company files for bankruptcy, there is a hierarchy of how lenders, creditors, bondholders, and shareholders are paid (ironically in that order). Here's the listed order:
    • Costs
    • Secured Creditors
    • Employees
    • Unsecured Creditors
    • Shareholders 

Bondholders are listed before owners of stock. Shareholders are paid last, so the odds of bondholders getting paid are greater than that of stockholders.

  • Risk/reward dynamics - for the reason above as well as the fact that bondholders get paid regularly by the company in the form of interest payments, there's less risk, so the opportunity for a greater reward is reduced.

Another thing to be aware of is the relationship between bond prices and interest rates. This has implications for your investment returns so pay attention. Bond prices and interest rates have an inverse relationship. When interest rates go down, bond prices go up...good. When interest rates go up, bond prices go down...not good. And that's what's happening right now with the FED. They've been raising rates, and appear as if they will continue, so bond prices have fallen and will continue to do so.

Other than the different types of bonds and the payout hierarchy, bonds are pretty easy to understand. Generally, less risky than stocks.

In the words of Forrest Gump, "that's all I have to say bout that."

Have a good week! All the best!

As always let me know if you have any questions!