New investors to the market typically know that there are three common ways to invest: cash, stocks (equities), and bonds. However, while most people think they know what a stock is, relatively few have as firm as grasp on bonds, including short term bonds.
Qai is here to bridge that knowledge gap. We’re going to discuss what a bond is, some of the distinguishing features, and recent legislative changes to bonds. All with a focus on short term bonds.
Bonds are fixed income securities that act as an IOU between the lender and the issuer. Issuers can be companies or governments of all levels, while lenders can be individuals or firms. Bonds are typically issued to raise capital for new projects or hiring initiatives.
All bonds come with specific details. These outline their interest rate, how often payments will be made, and when the issuer will purchase the bond back. Important terms to know in bond investing include:
- Debt market: the term for the overall bond market
- Maturity date: the date on which the issuer has to pay back the principal of the bond
- Face value: how much the issuer will pay the bondholder at maturity
- Coupons: interest payments
- Coupon rate: interest rate
There are several types of bonds, ranging from various national government bonds (called Treasuries), state and city bonds, and corporate bonds. Each of these come with its own regulations and risks. They each can be short term bonds, as well.
Bonds can also come with several types of “embeddable” options, decided on by the issuer. For instance, some pay zero interest, but sell for a lower price than face value. Others allow either the issuer or the lender the chance to return the bonds to the issuer before the maturity date. A few bonds even allow the investor the chance to turn the debt into stock in the company.
3 Types of Bonds
There are three main reasons to invest in bonds, including short term bonds:
- Generating income via coupon payments
- Diversifying a portfolio and reducing risk
- Holding capital while putting it to work
Bonds have made headlines recently as the result of a Federal Reserve initiative to bolster the market and reduce term premiums. Essentially, new legislation was enacted that will allow the Fed to increase credit throughout the economy and encourage companies to spend, lend, and borrow money. This was done by removing certification requirements for issuers and allowing the Fed to purchase corporate bonds on standard indexes rather than focusing on ETFs.
What are Bonds?
Bonds are known as fixed income securities, also known as a debt security. These are loans or IOUs between the lender (the investor) and the issuer (typically a company or government) that provide a fixed interest payment to the lender. The purpose of a bond is to raise capital for various projects; the exact appointment of which is decided upon by the bond issuer.
For instance, governments often use bonds to cover expenses such as infrastructure improvements (roads, government utilities, etc.) and wartime purchases. Governments may also use funds for purposes such as building new schools or funding various social projects.
Companies borrow bonds for several reasons, but the primary benefit is that it’s a way to quickly raise capital without selling stock or borrowing from a bank. Companies can use this capital to fund new projects, hire employees, build a factory, etc.
All bonds come with details of the loan and repayment, such as when the bond owner will receive their principal back, as well as what the interest rates are. Bonds are considered low-risk investments because of these terms. Usually, a bondholder will receive interest payments a set number of times per year until the contract is up, at which point they will receive their full principal back.
What Are Short Term Bonds?
A short term bond refers to a bond that has a short time to maturity. These bonds mature in one to four years, which is considered a short period of time. After all, some long term bonds can span decades. Consider 30-year Treasury bonds, for example.
There are also some bonds that mature in even less than a year, such as the 90-day U.S. Treasury bonds, which are known as ultra-short-term bonds. They are also known as cash equivalents.
When short term bonds reach maturity, the bond issuer has to pay off the bond. They may also pay back the principal investment or the bond’s face value.
Shorter bond terms typically means less risk for investors.
How Do Bonds Work?
When an entity needs to finance a new venture, they can issue a new round of bonds to investors. Typically, these bonds are traded on public markets, though some trade over the counter (OTC) or in private sales. The bonds trading network is known as the “debt market” because the transactions are selling corporate debt to investors, who then become debtholders until the company realizes the bond.
The borrower (issuer) issues bonds on the debt market with exact details on interest rates, interest payments, and the date of repayment for the principal. This last date is known as the maturity date – when a bond “matures,” the issuing company has to pay the holding investor the face value of the bond (the principal).
The issuer is responsible for setting the face value of the bond, typically at par with a face value of $1,000 per bond. The face value is how much the issuer will pay the bondholder come maturity.
The face value is an important metric to known because bonds frequently trade investors’ hands after the initial purchase. For instance, it’s not uncommon to find some types of bonds on the secondary market trading for $950, when the face value of the bond is $1,000. Furthermore, some bonds may issue at an initial price of $1,050 but name a face value of $1,000– still a fair trade if the bond pays interest.
These interest payments, also known as coupons, are the primary way in which a bond generates returns to investors. These payments are made at set coupon dates. It’s common to see semiannual (twice yearly) coupon dates, but not all bonds will set the same coupon dates – or the same coupon rates.
The coupon rate is the interest rate of a bond. The terms of the coupon rate will be spelled out in the bond when it is issued. Some bonds may offer variable interest rates, while others have fixed interest rates.
The exact coupon rate is determined by several factors, most importantly the creditworthiness of the issue and the time until maturity. For instance, companies with poor credit are by definition at a higher risk of default on their bonds. Therefore, they pay higher interest to compensate for the fact they may be unable to pay back the bond come the maturity date.
On the other hand, companies that issue bonds over a period of years or even decades pay higher interest rates to balance the risk of inflation against the coupon. It’s worth noting here that TIPS (a type of Treasury bond) are an unusual government bond in that they pay interest and also adjust the principal for the price of inflation throughout the bond’s lifetime. This is another way that bonds can protect investors against the risk of inflation.
What are the Main Types of Bonds?
A bond’s type is determined by the issuing entity. There are four main types of bonds available on the market, each with various subtypes that carry different terms.
- Corporate bonds are issued by companies. These are some of the riskiest bonds available but can offer greater rewards.
- Investment-grade bonds have a higher credit rating than high-yield bonds but may offer lower interest.
- High-yield bonds have a lower credit rating than investment-grade bonds but offer higher interest as compensation.
- Municipal bonds are issued by states and cities. These bonds are usually a safe bet but do carry some risks.
- Government bonds are issued by sovereign governments; collectively called “treasuries.” Typically, these are the safest kind of bond for investors to buy. Many Treasuries are zero-coupon, which means they pay no interest.
- Bills mature in one year or less
- Notes mature in 1 to 10 years
- Bonds mature in 10 years or more
- TIPS (Treasury Inflation-Protected Securities) adjust their principal according to the Consumer Price Index to eliminate the risk of inflation. These pay semiannual coupons and come with 5, 10, and 30-year maturities.
- Agency bonds are issued by government-affiliated companies such as Freddie Mac. These bonds typically have lower interest rates than some corporate bonds but higher rates than government bonds.
Note that it’s also possible to purchase bonds issued by foreign governments on some markets. However, due to the differences in terms and regulations, we won’t cover these here.
What are the Main Varieties of Bonds?
In addition to the issuing entity, bonds are also classed by variety. For the most part, these are embedded (optional) terms that a bond can take. A single bond can have all or none of these attributes at a time, which is why many investors turn to bond professionals to help them select which bond is right for them.
Varieties of Bonds
Zero-coupon bonds, as the name implies, do not pay coupons. Instead, the issuing body offers them at a discount, and the investor makes a profit when they redeem the bond at full face value. A common example of this variety is a U.S. Treasury bill, which typically do not pay coupons.
Callable bonds give the company the right to buy back their bonds before maturity. Typically, this occurs when interest rates decline or a company’s credit rating increases. For instance, if Company Ex issues 10-year bonds at 15% interest in 2010 but discovers in 2015 that their credit has gone up, they can repurchase the bonds and reissue them at 10% interest. Callable bonds can be a risky bet for investors who use bond coupons as a source of income, but they provide improving companies with the chance to decrease their overall debt to their issuers.
Puttable bonds, by contrast, allow the bondholders to sell (put) the bonds back to the company before the maturity date. This can be a valuable investment for investors who believe that the bond’s value will fall, or its interest rates will rise, in the future. It’s important to note here that low interest rates mean a higher bond price, and vice versa.
Convertible bonds are an unusual type of bond that give bondholders the option to turn their debt holdings into stock (under certain conditions) in the future. For instance, if startup Company Ex needs capital for expansion but can’t afford the 15% coupon rate of the current market, they could offer convertible bonds at 10% interest, to be exercised when stock prices hit $50 per share. This allows companies to pay lower interest in the crucial early phases and gives investors a unique alternative to profit off the company’s success.
Why Invest in Bonds?
There are several reasons that an investor may purchase bonds, but the underlying principles come down to steady returns and lower volatility than other securities.
For instance, investors who use their portfolio to provide income now instead of in the future may invest in a large number of non-Treasury bonds to increase their income in the short-term. Most bonds pay interest semiannually – while the amount isn’t enormous, owning a large number of bonds can lead to hefty returns.
Furthermore, an investor may use bonds to diversify and reduce the overall risk of their portfolio. Properly utilized, bonds provide a safe way to balance risks in the stock market with steady returns and repayment of bond coupons and maturities.
Investors also use bonds as a way to “hold” their capital in a semi-safe place. An investor who keeps a bond until maturity will receive coupon payments and the principal of the bond upon maturity. This is a way to put your capital to work and receive it back at the end.
Bonds in Recent News
In March of 2020, the Federal Reserve slashed interest rates to near-zero. And it purchased $1.7 trillion in Treasuries in the months afterward. This venture was a play to “fix” the bonds market. It would do so by reducing term premiums, which in turn will reduce the costs of long-term borrowing.
Overall, this move was an attempt by the Fed to increase quantitative easing and purchasing as much long-term debt as the government could reasonably handle without tanking the market. (Quantitative easing is a policy wherein the Fed purchases large amounts of securities to increase liquidity and stability. The theory goes that this promotes economic growth and financial lending).
There are many reasons for the Fed to take such actions in unprecedented (and even precedented) times. Chief among these is the concern of another “taper tantrum.” Such as the one that occurred in 2013, when the suggestion of less quantitative easing sent investors scurrying to dump their bonds. The depression in the market that was expected from quantitative easing never occurred, But the moves by panicked traders caused another problem: tanking long-term interest rates for months to come.
However, it’s not surprising that the Fed is spending so much on bonds to correct the market. What is surprising is the new policy they’ve put in place to guide their buying program.
Bonds in Recent Legislation
After big U.S. companies issued a record $1 trillion in investment-grade corporate bonds, the public assumed corporations would slow borrowing. Due to the sheer scale of some of the largest companies, this move could have a detrimental economic impact.
To counteract the impact of slowed borrowing, in June of 2020, the Federal Reserve unveiled changes to its bond-purchasing policies. Specifically, the plan affects its $750 billion emergency corporate lending facility – but the effects won’t end there.
In simple terms, the Fed made a play to increase the flow of credit throughout the economy. It did so by easing restrictions during the pandemic. The two biggest changes the Fed enacted to encourage credit flow include:
- Buying eligible corporate bonds on standard indexes in the secondary market instead of focusing solely on corporate bond ETFs.
- No longer requiring certification that a company isn’t insolvent but also can’t access funding at reasonable rates
This new regulation also requires companies to prove they have no conflicts regarding the CARES Act. This is to prevent government officials who own qualifying businesses from taking advantage of the newly available funds.
The full effects of this plan are unknown as of yet. But the hope is that partially deregulating which bonds the government can purchase will bolster companies in times of need. The true impact of this plan, however, is yet to come.