Fixed-rate bonds have been a popular investment tool for centuries. Investors make an investment in a fixed-rate bond by lending money to the issuer for a specified time. At the end of the specified time (maturity), the issuer returns the investor’s money. In the meantime, the issuer pays the investor interest based on a fixed rate. Interest payments are typically semi-annual but can be annual, monthly or even weekly.
Different types of entities can issue bonds. These entities are looking to raise capital by borrowing money (principal) from investors. Bond issuers are mostly corporations or governments. A corporation may want to borrow money to run its business or pay for a project. In addition, a government may issue bonds to raise money for public services or to meet budget shortfalls.
For each bond an entity issues, it publishes an indenture. A bond indenture spells out the legal disclosures of the bond, including maturity, fixed interest rate (coupon), date of coupon payments, and certain covenants. Covenants place limits on the issuer to ensure the issuer can pay interest and principal at maturity. Fixed-rate bond investors like them because they’ve historically been a lower-risk option compared to stocks and other investments.
Why Invest in Fixed-Rate Bonds
There are many reasons why investors like fixed-rate bonds. One reason is that bond investors view bonds as a safe investment. By issuing an indenture, the borrower commits to making interest and principal payments to investors. The interest and principal payments come from the profits of a corporation, taxes received by governments or revenue from specific government services.
Asset-backed bonds are like folks borrowing money against their home. A corporation can pledge assets to back the bond in some instances. For example, a corporation may borrow money and pledge real estate or other property as collateral. If the corporation cannot pay interest or principal, the investors can claim the asset, sell it and get some or all the money the borrower owes them.
Another reason that investors like fixed-rate bonds is diversification. Bonds do not change in price as much as stocks or other investments. Wild swings in the stock market can cause investors to lose sleep. By investing in a portfolio of bonds, investors may feel better that their portfolio will be more stable over time. Many investors also chose to invest part of their portfolios in bonds and in stocks.
Though investors believe bonds to be safer than stocks, there are no guarantees. For instance, a corporation may go bankrupt or choose not to pay interest or principal. These are extreme cases, but they do happen.
If a bond issuer cannot make payments, the risk investors take called default risk. If a bond issuer goes bankrupt, it will sell all its assets and pay all its debts, like bonds. Asset-backed bondholders may get their principal and any interest due from the asset’s sale. Bonds not backed by assets will get the money left over from asset sales. Stockholders are last in line for money raised by asset sales.
Bond prices have historically swung less than stocks. Though, bond prices do change. When overall interest rates change, bond prices for fixed-rate bonds also change. For instance, say you hold a bond with a 5% coupon, and interest rates drop to 4% for new bonds with the same maturity. If you want to sell your bond, you can get a higher price because a seller can either buy the new 4% bond or buy yours for a higher price so that the yield to maturity is 4%. If you hold the bond to maturity, price changes are of little concern because you’ll receive your principal at maturity regardless of the price changes.
Fixed-Rate Bond Mutual Funds and ETFs
If you’re not interested in reading through indentures, disclosures or trading bonds, you’re in luck. Fixed-Rate Bond mutual funds pool investors’ money, and a fund manager invests money in the mutual fund for you. Interest payments for the bonds held in the mutual fund are paid to investors by the fund. Each mutual fund will charge a fee for its services.
Fixed-rate bond ETFs are a bit different. You own a basket of bonds through the ETFs structure instead of a portion of the pooled assets like a mutual fund. ETFs also have managers who invest your money in bonds. The ETF manager pays you the interest on each bond and charges a fee for their services. Though, fees are typically lower than mutual funds.
Bond mutual funds and ETFs can focus on certain types of bonds. For instance, they can hold only treasury, corporate or municipal bonds. Some can focus on short-term maturity bonds, which typically pay a lower coupon but may be safer. Managers can also invest in high-yield (junk) bonds that pay a higher coupon but have higher default risk.
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.