Bonds: a primer

An Overview of Bond Mechanics

A bond is a fixed income security. It is a loan made by an investor to an organization, such as a government or a corporation. When you invest in a bond, you agree to lend money to an organization with the requirement they pay you back on a certain date, known as the “maturity” date, plus interest. This is the reason for the term “fixed income.” The amount of income you earn on the bond is “fixed.”

Note: bonds have lots of jargon that can be difficult to navigate. We’ll do our best to make it simple.

The organization borrowing the money, known as the “bond issuer,” agrees to pay a certain amount of interest each year. This is known as the “coupon rate.” The amount of money a bond pays back at maturity is known as the “principal” or “par value” of the bond. As you look at your statements, think of bond prices as “cents on the dollar.” If you buy a bond at a price of 95, you are paying 95% of what the bond issuer is obligated to pay back to you at maturity. A quantity of 10,000 at a price of 95 is valued at $9,500 in total. Most bonds have a par value of 100, which means when the bonds mature, the investors are paid back at a price of 100, or 100 cents on the dollar.

For example, let’s say an investor buys a $10,000 worth of a 10-Year U.S. Treasury Note with a 4.5% coupon rate at a price of 100. This means the investor is loaning the U.S. government $10,000, which the government will pay back when the bond matures on its maturity date in 10 years. Over that time, the investor will receive $450 of interest each year (typically paid as $225 every six months) until the bond matures. At the end of 10 years the investor will receive back their initial $10,000 investment.

Now let’s say the market interest rate for that 10-year Treasury Bond rises from 4.5% to 5.0%. What does this mean for your bond? It means that as an investor, you would now be better off owning a new 10-year Treasury bond, because it pays more interest.  The new bond is more valuable.  The old bond is less valuable, so the price of it goes down.  In short, when rates go up, prices go down. The price of that old 10-year bond would fall to increase the effective or true yield (or payout) that the bond provides to new investors. This means that if an investor buys a bond, rates rise (the price of the bond goes down), and the investor then sells the bond, they are selling it for less than they paid for it. The bonds that you bought initially for $10,000 at a price of 100 now fall to a price of 95, and your bonds are now worth $9,500. Of course, the bond issuer is still obligated to pay back the $10,000 par value of the bond at maturity. As a result, we typically hold bonds until maturity. This ensures that you “lock in” the interest rate the bond was providing when it was initially purchased.

Conversely, when rates go down, prices go up. If rates fell from 4.5% to 4.0%, those old $10,000 10-year bonds could instead increase in price from 100 to 105 to be worth $10,500. Once again, the bond issuer is only obligated to pay back the $10,000 par value at maturity, so eventually the bond will get back to a price of 100 as it gets closer to the maturity date. As you might imagine, this means that the longer the time to maturity, or the “duration”, the more volatile the price of a bond can be, primarily in relation to movements in interest rates. If interest rates rise, a bond with a 20-year duration will decline four times more than a bond with a 5-year duration will decline.

When we look at buying a bond, we are most concerned with the bond’s “yield-to-maturity,” or the real rate of return you get from holding the bond until it matures. The yield-to-maturity includes both the coupon payment you get from the bond issuer and any change in price you get from buying the bond above or below par. For example, if you buy a 1-year bond with a coupon of 4% selling at 99, your yield to maturity would be the 4% interest plus the roughly 1% price increase from 99 to 100, for a total of roughly 5%. Like any security we buy, we think that maximizing total return (capital appreciation plus income) while limiting the risk is the primary objective.

 Primary Categories of Bond Issuers

Treasury Bonds. The largest bond issuer in the United States is also the largest single issuer of securities on the planet: the U.S. Treasury Department. As we write this primer in January 2025, there is more than $36 Trillion (with a “T”) of Treasury Debt in circulation, or about 70% of the value of the entire U.S. stock market. For all the U.S. government’s foibles, a Treasury bond is still considered one of the most secure investments in the world due to the United States government’s substantial revenue raising power and stability of the U.S. dollar. Treasury bonds are also the most liquid of any type of bond investment. Treasuries are traded actively every day, and the government issues new debt every month. As a tradeoff to their safety and liquidity, Treasuries usually have the lowest yield (interest rate) of any category of bonds. All other categories of bonds are judged on the additional yield, or “spread,” that they offer above a Treasury bond of the same maturity. Treasury bonds often perform better than stocks during market declines. For example, Treasury bond prices were up across the board in 2008 when the stock market was down 37%.

TIPS. In addition to traditional bonds, the U.S. Treasury also issues a unique type of bond called “Treasury Inflation-Protected Securities,” or “TIPS.” Unlike all other categories of bonds, TIPS do not have a constant par value. Instead, their par values increase in step with inflation over time and provide a rate of interest on top of that inflation adjustment. These bonds provide an excellent hedge against inflation within the bond portfolio. If inflation is low, TIPS will tend to underperform their traditional Treasury counterparts. If inflation is high, TIPS will tend to outperform.

Corporate Bonds. The next largest category of bonds in which we invest is corporate bonds, or bonds issued by private companies rather than governments. Corporate bonds tend to carry more risk of downgrade by credit ratings agencies or default in the event of bankruptcy, and they therefore provide investors with a higher yield to compensate for the additional risk. Corporate bonds also tend to be less liquid than Treasury bonds, though they are still widely and regularly traded.

Municipal Bonds. The final major category of bonds we use is municipal bonds, or bonds issued by state and local governments. These bonds have the advantage of being tax-free at the federal, state, and local levels if you live in the same state as the bond issuer. The tradeoff is that these bonds offer a lower yield to make up for their tax-free status. This means that municipal bonds are often more advantageous for investors in high-income tax brackets.

If you’d like to talk more about bonds and how they can or do work in your portfolio, give us a call at 585-943-0402 or send us an email at john@lyoncapital.com.

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