How Bonds Work: A Basic Primer

Investors have long relied on bonds for low-risk income and as a way to diversify away from stocks and real estate. Increasingly, different types of bonds have become available on the market, but many investors remain in the dark as to the mechanics of how bonds work.

Basically, a bond is a debt instrument that enables investors to lend money to businesses or the government in exchange for a fixed income based on the interest rate. The issuer usually pays interest, also known as the coupon, on a semiannual or annual basis. At the bond's maturity date, the principal is paid back in full to the investor.

Bond price

Bonds have four main components for investors to consider: price, duration, callability and coupon rate.

All bonds are priced in units of $100, even though most bonds sell in $1,000 denominations or higher. If a bond sells for "par value," it's selling for face value. Since bonds are traded on an open market, the price that they fetch can go up or down, similar to the price of a stock. When prices go below $100, the bond is priced at a discount; above $100, it is priced at a premium.

Bond prices tend to be tied to changes in interest rates. When rates rise, bond prices go down. That's because older bonds with lower rates are competing with newly issued bonds sporting higher rates. Investors don't want to pay as much for a lower-yielding bond if they can get one that pays more.

Conversely, when interest rates fall, bond prices go up.

None of this matters if you hold a bond to maturity because you'll get back the face value of the bond -- unless the issuer defaults. However, investors in bond funds can get hammered when fellow investors stampede out of the fund, forcing fund managers to sell bonds at an inopportune time to meet redemptions.

The price of an individual bond is not the most important consideration when buying a bond, says Tarren Schaar, a Certified Financial Planner professional with JLFranklin Wealth Planning. "Price is just one piece of the puzzle -- and I'd say duration is much more important," he says.

Duration and callability

Duration measures how long it takes for a bond to be paid back by its cash flows. Expressed in terms of years, duration also gives investors an idea of how sensitive a bond is to changes in interest rates. The higher the duration, the more sensitive it is.

"Duration shows the sensitivity to changes in interest rates," says Schaar. "A 1% rise in interest rates results in the loss of about 8% of the value of a bond (with a duration of) eight years," while short-term bonds generally don't fluctuate as much in value, he adds.

The duration computation is affected by a number of variables, including yield and call features.

Some bonds are "callable," meaning that you will receive your principal and interest only until the issuer decides to redeem its bonds early and pay you back in full. Many bonds are callable as soon as you buy them or after a grace period of a few years. In most cases, callability does not favor the investor, partly because it gives the bond issuer more options and the investor less control.

"Callability really favors the company or organization that's issuing it," says Schaar, who doesn't recommend buying bonds with call provisions.

Getting income from a bond

So how much interest does a bond pay? When bonds are first issued, they have a coupon rate. For new bonds and bonds selling at par, the coupon rate is identical to the interest rate investors get as a yield on their investment -- that is, how much return the investor gets on the investment.

"You need to understand what's going on in the market to know why something is offering a higher yield," says Patrick Luby, managing director of fixed income at Charles Schwab. "To start, you need to look at the bond's coupon rate and its current price."

The coupon rate of a bond never changes, but the yield does. This is because a bond's yield is a ratio between the coupon rate and the bond's current price. When a bond goes down in price, its coupon rate stays the same, but its yield rises.

If you buy a bond and hold it to maturity, you don't have to worry too much about changes in the price and yield because you still will get paid the same rate. "Investors can calculate the yield they will get by comparing how much they paid for the bond and the coupon rate," says Schaar. "However, they should also consider whether the bond income will be taxable for them or not, which is an added complexity to the system."

Tax-free bonds can offer a much better yield than they appear to, if you consider the tax savings. "If I can get 5% on a municipal bond, the taxed equivalent is closer to 8%. That's a greater return than the 1% you get on most CDs," says Terry O'Grady, head municipal bond trader of FMS Bonds.

But some tax-exempt municipal bonds can be taxable to investors in certain circumstances. Investors should speak to a financial planner or tax professional to determine if they will have to pay tax on income from a bond, says Schaar.

What's important about bonds

Judith Burns of the Office of Investor Education and Advocacy at the U.S. Securities and Exchange Commission encourages all investors to examine the risks associated with bonds. She suggests that investors do their homework independently before making a purchase, and then consult with a certified financial professional.

Schaar agrees, adding that many investors tend to focus on the wrong things. "I think investors tend to focus too much on how much income a bond will generate, but that really depends on what type of income the bond will be generating and the investor's individual situation," says Schaar. "People tend to focus too much on cash flow, but looking at how much your bond is at risk of default and declining value amongst rising interest rates is much, much more important."