Bonds and stocks are the two basic building blocks of any investment portfolio. Bonds are, undoubtedly, the less understood of the two. A stock represents ownership in a business, and the stockholder shares in the profits and losses of the business. But what about bonds?
A bond is a surprisingly simple concept in spite of the mystique that surrounds it. What is a bond? It is simply an IOU. Like any IOU, it has four parts:
- Dollar amount
- Interest rate
- Loan due date
Let’s look at these four parts:
Dollar Amount: This is the amount that is owed that will eventually need to be paid back. The amount is always set as a multiple of $1,000.
Interest Rate: The interest rate is the periodic payment received by a bond holder during the life of the bond. That interest rate is set at the time the bond is issued and (for most bonds) never changes. This interest is paid twice per year.
Loan Due Date: This is the date at which the loan must be paid back and interest ceases to be paid. (Some bonds may be paid off before the due date.)
Issuer: This is the crucial factor for any loan. Who stands behind it? For a bond, the issuer is known as the “borrower,” or the one borrowing money. The greater the financial strength of the issuer, the higher the chance that (a) the lender will receive the interest due to him/her and (b) the loan will be paid off when it’s due. (Would you accept an IOU from someone with a history of poor financial standing?)
Because identifying the bond issuer is so crucial, bonds are categorized by the issuer type. There are three categories of bond issuers:
- Federal government (Commonly referred to as “treasuries”)
- State and local government (Commonly referred to as “municipals” or “munis”)
- Businesses (Commonly referred to as “corporates”)
Here is an example of each category:
Amount Issuer Rate Date Due
Corporate $5,000 Microsoft 1.0% August 10, 2018
Treasury $7,000 U.S. Treasury 0.875% July 15, 2018
Municipal $10,000 State of Michigan 0.64% October 15, 2018
Note that a certificate of deposit (CD) is an IOU that has been issued by a bank. It still has the four parts of a bond as described above.
If whenever you hear the word “bond” you immediately think “IOU,” you will be well on your way to a better understanding of the nature of a bond.