Video: Learn Bond Basics in Minutes

A previous series of short videos called Why Bother With Bonds? addressed why certificate of deposit (CDs), bonds, and bond funds are critical to building an all-weather portfolio—even during low interest rates. Now learn the basics—what every investor should know about bonds and fixed-income securities.

Bond Basics 1: What is a money market fund?
Should you choose a money market fund or a bond fund? Or perhaps dividend-paying stocks? Learn how each of these differ in this episode.

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Transcript

At first glance, some investing options look similar. Consider this: Which types of investment will give you both a stable income stream and keep the principal at a stable value? In other words, if you have $40,000, is there a way to invest it such that every month they’d pay you a fixed amount, say $100, but at any time you desire you could stop and get your $40,000 back?

 Would you look for: a Money Market Fund, a Bond, a dividend-paying stock, or none of these? Make your best guess. Click on one, and then I’ll tell you the answer.

Stocks pay dividends. Buying a stock is buying ownership in a company. You can own it forever. You might wonder about whether these dividends are like bond dividends—after all, they are both called dividends, and both are payments on specific dates. But stock dividends are not contractual obligations with stockholders—they can be changed at any time, even eliminated. And the value of the stock moves with the stock market. No guarantees; but probably not the best answer to our thought problem.

A Money Market Fund does guarantee to protect your investment. It’s a perfect place to stash your cash for the short-term. You can always get back your investment, plus they pay you some interest for that money every month. But, the interest rate varies so it cannot be relied upon to provide a stable income stream.

Bonds do that. They are a simple loan for a fixed length of time, and in return you get a fixed dividend every period and your money returned at the end of the term. So, bonds can assure you a stable income stream, but the market value of the bond can fluctuate over the term. In fact, it varies every time interest rates change. The price wanders in a totally unpredictable direction (since you can’t predict interest rate changes) but gradually drifts towards that one date when you’re guaranteed to get your investment back, the end of the term when the bond matures.

Correct. It’s “none of these.” So, to summarize: You can have stable income stream or stable principal value, but you cannot have them both.

Bonds can be a general term, but now we’ve seen the reason why fixed income securities is a better term that describes what is common about this whole category of investments. Learn some surprisingly interesting things about CD’s in the next video.

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Bond Basics 2: Sometimes CDs are better than bonds.
Sometimes CDs are better than bonds! Learn the rare advantage that small investors have over institutional investors in this episode.

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Transcript

A certificate of deposit (CD) offers a higher interest rate than a Money Market Fund or a bank savings account but you don’t have access to your money for a period of time without paying an early withdrawal fee. CD’s offered by a bank or credit union are simple interest-only bonds that are sometime very attractive. The highest paying CDs have higher yields than Treasury bonds and give the small investor a rare advantage over conventional bonds and brokered CDs. For instance, today the annual yield on a 5-year Treasury Note is about one and a half percent. But, in contrast, the yield for CD’s with equivalent term and risk varies from a high of 3% to nearly zero. Wow, that’s quite a range, isn’t it. CDs are like bonds in that they provide fixed monthly payments but cannot guarantee the full return of principal before the end of the term. The amount of the early withdrawal fee is limited: commonly 3 to 12 months of interest, depending on the bank or credit union. While that’s generally true, look at this: this credit union offers an exception for CDs in IRA accounts if you are over some age. I don’t mention this to advertise this credit union, but rather to emphasize the point that while the bond market is incredibly efficient, the CD market is not, and that creates some attractive opportunities for individual investors.  Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: Sometimes CDs are better investments than bonds. (T) Here’s the other: Large institutional investors invest in CDs. (F)

This is False. CDs are issued to individuals by banks or credit unions, and insured by these federal agencies. So CDs—like U.S. Treasury Bonds—have essentially zero credit risk. But the FDIC or NCUA insurance levels are limited to amounts that make CDs attractive to individuals, but inappropriate for large institutional investors. This is True. Keep in mind that Bank CDs aren’t negotiable—meaning, you can’t sell them in any market. To redeem them you must go back to the bank (or credit union) where you purchased it. But as I have showed, sometimes CDs are offered at above-market interest rates with low early withdrawal fees.

If you can lock-in a CD with a higher rate than the equivalent Treasury Bond, then you obviously come out ahead for no additional credit risk. If interest rates go up, it can be even better! I’ll show you with a simple example. Here, you buy both a 4% CD and a 4% Note. Towards the end of the first year, interest rates increase to 5% and you’d like to replace both to take advantage of the higher interest rates. To sell your CD you will have to pay an early withdrawal penalty, which we’ll say is 3 months interest for this example. Our annual interest rate divided by 12 is the interest rate per month, which we’d multiply by 3 months to get the early withdrawal penalty. Note that it remains one percent of the amount of the CD for any day after that until the CD matures. But an ordinary bond is different. There is no early withdrawal penalty, but its price changes every time the interest rates changes, and the amount the price changes gets smaller as the bond approaches maturity, or more precisely, as the bond duration approaches zero. Remember, we bought this bond one year ago so there are now four years left on this bond. For now, let’s say the duration is also equal to four years A bond price always changes in the opposite direction as interest rates by an amount equal to the rate change times the duration. So our simple estimate is that the cost to refinance the bond is four times more than the CD, which is our point. Sometimes, CDs are better than bonds. Again, you’re not going to get rich with bonds, but bonds are a critical elements for controlling the level of risk in any portfolio, so it’s vital that you understand the basics about how they work. Now if you understand how CDs work then you are well on your way to understanding how other bonds work—that’s next!

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Bond Basics 3: What are bonds?
Bonds are simple interest-only loans. It's that simple! Learn what every investor should know about bonds and fixed-income securities.

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Transcript

Unlike buying a stock—where little is promised but the potential reward is unbounded—with a bond, everything is spelled out, and you don’t get more than that. If we draw it as a picture, we’re going to expect interest payments over regular periods but none of the principal is repaid until the end of the loan.

When the borrower is a bank or credit union, these agreements are called certificates. When the borrower is a government or corporation, these are called bills, notes, or bonds, depending on the length of the loan. They have a face value—which is the amount you’ll get back at the end of the term of the agreement, and a coupon which specifies the fixed dollar amount you’ll receive every year as interest, in either monthly or semi-annual payments. Bonds with longer terms or poorer credit ratings need to offer higher coupons to attract investors.

The coupon rate never changes. That’s the reason that bonds, like CDs, are called fixed-income investments. What makes these different from an IOU, a loan, or even a bank CD, is that these are “negotiable”—meaning you can buy and sell these in a market, for the current price.

It’s a competitive market, and that price is determined by the prevailing interest rate for similar bonds. There is only one day that the price has to be equal to the face value of the bond, and that’s its maturity date.

Interest rates move around daily. Today’s interest rate for a 5-year treasury note is around one and a half percent. At one point 30 years ago it was over fifteen percent. Rates are determined by supply and demand in the market.

The credit rating of the issuer is very important. Many corporations with outstanding credit ratings also issue bonds to raise money. Corporations with weaker credit ratings need higher coupons to attract investors, so these are called “high-yield bonds”.

Now, as always, beware of marketing. While high-yield certificates are good, because they are government insured, high-yield bonds are bad—at least from our point of view that it’s better use high-quality bonds to stabilize your portfolio and keep your risk in your stock investments. Because, in addition to default risk, junk bonds tend to go south when the stock market tanks, exactly the wrong time!

 Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: All bonds are subject to interest rate risk—unless held to maturity. (F) Here’s the other: Bonds prices vary with interest rates but not grow like stock prices do. (T)

This is False. Interest rate risk (also known as price risk) refers to the risk that the price of a bond will fall due to an increase in interest rates. There are no exceptions. When interest rates rise, and you have your money locked-up in a bond, you are missing out on investing that money at the new higher rate. The bond you own is instantly worth less from the amount of your lost opportunity. It’s a lost opportunity even if you hold it to maturity and get each and every payment as promised, on time.

This is True. The market prices for Bonds do not grow the way stock prices do, but their prices do fluctuate with interest rate changes.

The value of a stock reflects what people perceive the future profits will be for a company. So as a company grows, the value of the stock appreciates.

Not so with bonds. A bond price, and the current interest rate, are directly connected, but the effect is not permanent.

To see this, consider a 5-year Treasury Note. If interest rates never change, the market price for that bond would remain flat every day for five years.

But if interest rates went up 1% at the end of the first year the value is immediately worth a few percent less. Still, that Note will be worth exactly the face value on the very last day.

And if interest rates fall, the opposite occurs.

If interest rates fell an additional 1% every year for the life of the bond, the value of the bond might look like this. Intuitively this is what you’d expect, because your bond locked in higher interest rates that what’s available in the market, but that ceases to have any additional value when the bond matures and is worth the face value.

Now, can you see that the same size interest rate changes have a bigger impact on the bond price when the maturity date is further away?

Bond prices move instantaneously in the opposite direction when interest rates change by a factor you can control called “duration”. Now I want you to see that if the interest rate were to instantly rise 1%, the price of a bond (or bond fund) with a 1-year duration would go down 1%. Down 1% causes a price rise of 1%. Longer-term bonds, and bonds with smaller interest payments, are more sensitive to interest rate changes because they have a longer duration. If the duration is 8-years, then a 1% change of interest rates causes the price to change by 8%.

The primary point is that a bond price isn’t merely influenced by interest rates, they are directly connected by math.

We care about price sensitivity so we can invest in the appropriate type of bonds. We don’t expect to get a return because of interest rate changes—because nobody can reliably predict interest rates. We’re investors not speculators, so we’re more concerned with total return which includes the dividends and reinvested dividends.

Next, we need to clear up the confusion about whether to buy individual bonds, bond funds, or bond ladders. That’s coming up!

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Bond Basics 4: What is a bond ladder?
Learn at least two very cool things about individual bonds and bond ladders in this episode.

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Transcript

If new bonds are purchased as older bonds mature, then you get a recurring, or rolling, ladder. A ladder may be comprised of any sort of bonds to effectively achieve a self-managed fund. In practice, it’s only practical for CDs and U.S. Treasuries—because you can purchase these without a transaction cost or commission.

So if you have the time and discipline, you can build your own fund—thereby avoiding the expenses of a managed fund. That would be one of two good reasons to use individual bonds rather than a bond fund. But it’s hard to beat the expense ratio of a good bond fund and we’ll talk about these in the next video.

The second good reason to own individual bonds is a little less common, but it’s worth mentioning.

Last video we introduced the concept of “duration” as a measure of a bond’s price sensitivity to a change in the interest rates. A bond fund usually maintains a relatively constant duration. But both an individual bond or CD, and a non-rolling bond ladder, has a duration that decreases over time to zero. This means they become less sensitive to interest-rate changes as they approach maturity. That makes them perfect to fund a date-certain future liability. In fact, you could continue to buy them for that target date as I’m showing here. This collection of CDs or bonds is called a non-rolling ladder.

 Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: Bond ladders can have lower annual expenses. (T) The other: A bond fund is riskier than a bond ladder. (F)

A bond fund is no riskier than a bond ladder with the same duration. All bonds have interest rate risk, and a fund is just a portfolio of individual bonds. If interest rates rise, whatever kind of bond you own is instantly worth less. It doesn’t matter if you stay invested and don’t realize the loss, it is worth less from the amount of the opportunity you are losing out on if you could invest at the new higher rate—or if you’re using CDs, limited by the amount of the early withdrawal fees.

But suppose you answered the question thinking of a long-term bond fund and a short-term bond ladder? Well, then it would be riskier, and kudos to you if you recognized that. The importance of duration is one of the most important things to understand about bonds.

This is True… It is usually possible to buy CDs, or Treasury Bonds when issued, without a fee. So a rolling ladder comprised of these would be a way to create a bond fund with the lowest possible annual expense.

However, stay away from other types of individual bonds. They often come with hefty fees of a few percent that are, unfortunately, not visible to ordinary investors. You’re usually better off buying a low-cost bond fund, and that’s what we will talk about next.

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Bond Basics 5: Individual bonds? Or a bond fund?
Should you own individual bonds or a bond fund? Learn why the answer is easy in this episode.

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Transcript

Individual bonds, or a bond fund? It’s an easy choice!

The major factors in deciding whether to use a bond fund come down to convenience, costs, and control over maturity. You don’t need much diversification if you use CDs and US Treasuries, and you can own these with no purchase fees or annual expenses.

Other individual bonds, on the other hand, can have spreads between the bid price and the asking price from one-half all the way up to five percent, and you will, unfortunately, have no idea that you are paying these hefty fees to your broker.

For most of us, a bond fund is a more efficient way of investing in bonds than buying individual securities. Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors to be invested professionally. This can be done at a very low cost.

The thing that some find confusing is that generally bond funds never mature. So while there’s not a specific date when they’ll return what you invested, the fund has a price and you can sell it at any time. Remember, we don’t expect this price to appreciate, like we would with the stock of a growing company. We care about the total return, which we’ll talk more about later, and sometimes we care about how sensitive that price is to interest rate changes. That sensitivity is best expressed by its duration. A short-term bond fund is less sensitive to interest rate changes than a long-term bond fund.

 Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: An interest rate increase can be good for investors. (T) Here’s the other: A bond fund is just as risky as a stock fund. (F)

This is False…First of all, a terrible year in the stock market is when the value of your investments drops forty to fifty percent. Whereas a terrible year in the bond market might be if interest rates suddenly jump a few percent causing the value of all bonds to drop. Hang on though, if you chose a bond or bond fund that you’ll hold for longer than its duration, then rising interest rates are actually your friend.

This is True…If you reinvest dividends at the new higher interest rate, then you come out ahead if you hold bonds for longer than their duration. Let me make an example to illustrate this.

This investor buys a 30-year 5% Treasury bond at par, and seconds after it is issued, yields suddenly rise to 10%. This bond is now worth less than 53 cents on the dollar. However, since this bond throws off coupons which can be reinvested at the new higher yield, it takes our investor less than 11 years to break even—so this defines the bond’s duration. And note that because of the coupons, the duration is always less than the maturity, sometimes considerably so. To reiterate, after 11 years, this investor is better off for the fall in price because of the rise in yield. The duration is the period of time at which you are indifferent to interest rate changes.

Let’s stop and recap this series so far:

Bonds are essential to every investment portfolio—even when yields are at record low levels—because stocks are so risky. Owning the right amount of bonds helps make that stock market risk palatable. They’re the perfect investment when you need money at a specific time. And bonds that are uncorrelated with the stock market are a very attractive diversifier.

Stocks, Bonds, and Money Market Funds are each very different, and we took a look at this to introduce this current series about bonds. CDs are a special type of bond, and we looked at how and why, sometimes, CDs are better than bonds.

Then we talked about bonds and their two major attributes: the quality (or credit rating) of the issuer, and the length of the bond. We saw how a bond price is tied to the interest rate, and introduced the concept of “duration” to describe price sensitivity.

It is easy to buy CDs and individual bonds from your bank or broker and make a bond ladder. This is interesting for the lowest possible annual expenses, and when you want them to mature on a specific date for some reason.

For most of us, a low-cost bond fund is the way to go and we looked at how duration helps us decide between short-, intermediate-, and long-term bond funds.

The next set of videos to finish this topic will be about the risk and returns of bonds, and tips about how to stay ahead of inflation.

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Video production credits
These videos may be freely shared under the terms of this Creative Commons License.

The author, Rick Van Ness, uses short videos to promote the Bogleheads® investment philosophy on his YouTube channel (YouTube.com/FinancingLife101) and his website (FinancingLife.org).