January 29, 2024

It is commonly recognized that bonds play an important role in portfolios. However, many people can’t explain what a bond is or how it works. This post will attempt to explain how bonds work as well as state the risks associated with bonds. These risks are important to understand because there is a common misconception that bonds are risk free and I can assure you that is not the case.

A bond is quite similar to an I.O.U. An organization borrows money from an investor and promises to pay them back in the future. The borrower can be a business, a local government or even the federal government. The risks that the investor faces from investing in a bond vary depending on who issues the bond (the borrower) and the characteristics of the bond itself such as its length to maturity (when the investor needs to be paid back in full). The most common risks associated with a bond are credit risk (the risk of being paid interest and principal on time), interest rate risk (temporary changes in the value of the bond due to interest rate changes in the broader market), and re-investment risk (the risk of not being able to re-invest the proceeds from the bond at a similar or higher rate in the future).

When the money is borrowed, the borrower not only promise to pay the money back by a specific date but they also promise to pay interest to the investor for the privilege of using their funds. The interest is often paid over regular intervals. For our purposes we will use a very simple example with round numbers to illustrate: An investor lends a business $100 with the promise of being paid back in 3 years (maturity date). The market rate for bonds of this type is 5%. The investor can expect to receive $5 per year in interest from the borrower once a year for 3 years. Additionally, at the end of the three years, the investor not only receives their $5 interest, they also receive their original $100 principal investment back. Of course, this is a very simplified example and other bonds can work somewhat differently.

The next post will take this explanation a bit further to illustrate how some of the risks of bonds show up for an investor.