Learn about Bonds, How They Work, What You Need to Know and How They Interact in Your Portfolio

Continuing along with this series of basic tools, financial concepts, and things you need to know to build your wealth, today, we’re going to talk about bonds. [music]

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, author of the upcoming book Core4, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), and host of The Retirement Income Show. Bonds are one of the most misunderstood tools in all of financial planning.

Today, we’re going to get into the details in a basic sense of how bonds work, what you need to know, and how they interact with other tools inside your portfolio in the role of bonds. A bond is nothing more than a loan to a corporation in its most basic sense. Apple, GE, Microsoft, you can make loans essentially to these large corporations. In exchange, they promise to give you your principal back at maturity, plus an interest rate along the way.

If we replace the word bond with corporate loan, us making a loan to that corporation, it makes it a little bit easier for people to understand bonds. All bonds have an initial principal amount of $1,000. They offer you an interest rate, in this example, 3%. That 3% is of 1000, so $30 per year in interest. Now, bonds normally pay semi-annual interest, so that would be two payments of $15, typically six months apart. Then they come with a term or what we call a maturity. This is an example of a 10-year bond. If you loan Microsoft $1,000 for 10 years, they may pay you 3% per year in interest, and that’s what a bond is. Microsoft guarantees that at the end of the term, they are going to repay you your $1,000 and in the interim, you’re going to collect $30 a year of interest.

If you want to invest 10,000, or 20,000, or 50,000 in bonds, you would just buy 10, 20, or 50 of these bonds, all of them, $1,000 in principle denominations. Now, once a bond is issued at $1,000, we call that par value, it trades just like a stock in the open market, the price of the bond can go up, the price of the bond can go down. When the value of a bond goes up, we call that a premium bond. This is an example of the bond selling for $1,100. If you want to buy it three years into its term, it may be selling at a premium, and you’d have to pay more, which means the interest that you earn would be less, but bonds can also go down in value.

Bonds are not safe investments, they are less risky investments than stocks, but bonds do fluctuate in value. A discount bond is an example of a bond that has started trading, and it has went down in value, so you could buy it for less than what the original issue price was of $1,000. This means that 3% interest, you’re actually going to be earning a little bit more interest. Bonds can sell at a premium or a discount. They have a principal amount that you will get back at maturity. They also pay an interest rate along the way. Now you can buy individual bonds, or mutual funds can be comprised of hundreds of different bonds. That’s what we call a bond fund.

Now the big difference between individual bonds and bond funds is that you’re not guaranteed with a bond fund to ever get your principal back. There is no maturation date with a bond fund. The manager who manages that fund is simply buying and selling bonds throughout the course of the year, and you have one price like $25 a share or $30 a share, and that value will fluctuate as time goes on, and you have no guarantee to get your original principal back.

Now in this interest rate environment, bonds are not the most efficient tool, they pay low-interest rates, a lot of bonds are selling at premiums, and when you factor in taxes and inflation, a wide majority of the safest bonds out there actually have zero returns or negative real returns. Bonds can be a tool in a portfolio that reduces risk, they can still be used in an appropriate way, but in this environment with interest rates really low and expected to rise over the next 5-10 years, bonds aren’t necessarily the most efficient tool out there.

This has been a primer to bonds, we wanted to give you a quick introduction and an understanding of how bonds work, the role they play in a portfolio, and some of the challenges that they face in this economic environment.

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