In The Intelligent Investor, Benjamin Graham encourages investors to divide their holdings among two broad types of investment: bonds and stocks. He recommends dividing an investors’ portfolio between them from 25% to 75%, depending on the investors’ financial goals. Because stocks provide all the glitz and glamour of Hollywood the most investors understand how they work (or at least they think so). However, bonds are the ugly understudy and as a result can be misunderstood.

Because bonds are supposed to play such an important role in our portfolios, this series of articles on bonds will take us through the basics of bonds, describe the type of bonds available, provide links to resources and lay the groundwork for us to begin investing in them. To begin the series we’ll start at the beginning: what are bonds? We’ll go over what they are, how they make money, and basic pricing considerations.

In general terms, bonds are loans in the form of securities. They are offered by organizations like corporations and governments as a way to raise money by selling “shares” of a large loan to many groups and individuals. The two basic ways to purchase bonds are similar to stocks. An investor can build a custom portfolio or he can purchase a bond fund. One of the nice features of bonds is that you can sometimes buy directly from the bond issuer. For example, the Bureau of Public Debt setup TreasuryDirect as a way to sell U.S. Treasuries directly to the public, commission-free. For most other bond purchases, bonds can also be obtained from full-service brokerages and bond brokers for a commission.

Instead of buying individual bonds, they can also be purchased through mutual funds. The bond fund can be a convenient alternative to building a portfolio because the world of bonds can seem complicated and intimidating. This is primarily because of how many different types of bonds there are. However, there are benefits for the intrepid investor who can devote time to selecting the appropriate bonds to meet his needs, such as higher returns, and greater tax benefits.

The basic way an investor makes money on bonds is by earning interest. A bond’s “coupon” is basically its interest rate. The coupon’s name derives from the time when an investor would tear off a paper coupon from the bond in order to receive his interest payment. At 6.0%, one would earn $60 a year (typically in semi-annual payments) on a $1000 bond which would be paid until the bond matures and is bought back by the issuing organization.

The real world is more involved, though. After bonds are initially offered to the public (think IPO) their price can change. You could, in fact, buy a $1,000 bond for $900 or $1,100. In bond parlance, a bond price that is lower than the face value is called a “Discount”, while a price greater than the face value is called a “Premium”. Factors such as credit worthiness, time until maturity, and prevailing interest rates can all affect bond prices. The great thing about bond prices though is that interest is calculated based on their face value, so a bond can actually be earning interest off of $1,000 even if it costs only $900. This increases the effective interest rate, which is called “Yield”. Simple yield is calculated by the formula: Coupon / Price.

Of course, even yield is not so simple. When advanced investors refer to yield they’re actually referring to the yield to maturity (YTM), which is apparently a very complicated formula that I have not yet seen. This gives a truer picture of the actual rate of return for a bond and should be looked at first and foremost.

In summary, bonds are securities like stocks except that instead of being shares of a company, they are shares of debt. Investors earn money from bonds through interest payments, called coupons, but the effective interest rate changes based on the price of the bond, which is determined by our good friends, supply and demand. Finally, bonds can be purchased at full-service brokerages, and bond brokers.

To learn even more about bonds, take the action steps below and read the very good articles on bonds at Investopedia, and also look at the 100 level courses at the Morningstar Classroom.

Action Steps
[1] Read “Bond Basics” at Investopedia
[2] Take the free 100 level bond courses at the Morningstar Investing Classroom.
[3] Read more about bond funds at Investopedia

Additional References
“Bond.” Wikipedia. Dec 19, 2005.