Investment Guy

There are stocks and then there are bonds.  The bond market is infinitely larger than the stock market and much more influential on the economy as a whole, but it is far less understood by the masses.  The last year and a half has rattled all investment markets across the board, including the historically stable bond market.  The effect that bonds have on brokerage statements and account values is often misunderstood.

First let’s talk about what a bond is and then I will explain how the market effects the value of an investment in bonds.

A bond is debt, issued by an entity that wants to borrow money.  It is a loan, plain and simple.  In principle, it is identical to you, an individual, going to a bank to borrow money.  You borrow money, pay the bank interest, and eventually you will have to pay back the full amount of the loan. 

In lieu of obtaining a loan from a bank, when a company wants to borrow a large sum of money, they will often issue a bond.  Individual investors play the role of the bank, and ‘buy’ the bonds increments of $1000.  Each bond will have a stated interest rate and specific date at which the bond will mature and pay back the loan.

What does all this mean to an investor?  Let’s use the fictitious company the Clam Shack as an example.  Business has been great and management decides that the time is right to expand.  The Clam Shack wants to open 5 more shacks, and determine the need to raise $10 million.  After having their finances evaluated they have been rated AAA and learn that it will cost them 5% to borrow annually for 10 years.

Now, assume that you buy 10 of the 5% Clam Shack bonds.  You have invested $10,000 and will receive $500 in interest payments annually for the next 10 years, and after 10 years you will receive your $10,000 back.

The Secondary Market
Once you own this bond it will show up on your monthly brokerage statement.  However, there are some important things to be aware of.  The bond market is constantly moving and will change from day to day.  The bond market moves much like the stock market, reacting to news, statistics and other indicators.  Your bond will usually be priced on your statement above or below the par value of $1000.  This is an indication of the current state of the bond market, and your bonds relative value.

You have likely heard the statement “the Fed just cut interest rates”.  Let’s assume the fed just cut rates 1%.  The 5% bond that your previously bought will go up in value.  Interest rates goes down, bond prices go up.  And vice versa; it is an inverse relationship. 

 We can easily illustrate this with our previous example.  When we purchased our Clam Shack bonds we were in a 5% interest rate environment.  Now that interest rates have been cut, if you want to buy $10,000 AAA bond you will only get 4% for a 10 year investment.

If you have $10,000 to invest, would you prefer a 4% or 5% rate of return?

This only matters if you want to sell your bond before the bond’s maturity date.  There is a secondary market for bonds that will adjust all prices so that there is a level playing field.  and the 5% Clam Shack bond that you own will be more desirable for anyone seeking income.  By paying $10,800 for annual  income of $500 you will receive an equal investment of $10,000 for $400 interest annually. (approx)

So your brokerage statements will always show the amount of money you will get for your bond if you sold it on that day.  If your statement says you have a $10,000 bond investment worth $9,000 you will still receive $10,000 at maturity.

This is an explanation of how bonds are priced on your brokerage statement.  There is a lot of information to consider when investing in bonds including default risk, reinvestment risk, liquidity risk, and inflation risk to name a few.