Ever since the Presidential Election, more and more people have been asking the question how do bonds generate income for investors? There are many reasons for this whether it be inflation potential or interest rates rising, bonds have seemingly have become popular overnight and a more realistic investment vehicle in some people’s eyes.
Most people associate bonds with interest payments but as far as we know, there are actually two ways to make money with bonds. We will spend the rest of this short article explaining those two.
How do Bonds Generate Income For Investors? Yield!
Let’s dive right into an example. For this example, we are going to use the type of fixed income (bond) instrument that is seen as having the least amount of risk, the US 30 Year Treasury Bond. Why are these seen as almost no risk (hence, a commodity)? Because they are backed by the United States Government which always has a few tools at its disposal to pay back debt holders (bond holders).
- The US Government can raise taxes
- The US money can borrow more money from the Federal Reserve at lower rates than the interest on the 30 Year Bond
It is assumed since both of these cases are realistic that the US Government Bonds are seen as the most riskless of all bonds.
Right now, let us assume the US 30 Year Treasury Bonds yield 3%. And for argument sake, let’s say we spend $100,000 to buy these bonds. What does that math look like?
Well, the par value of this bond is $100,000 for starters. And since the bond is yielding 3%, we can expect two payments a year each equal to 1.5% of the original par value principal amount (most bonds pay out their debt obligations twice a year). In this example, we would expect to receive an interest payment (debt obligation) in the amount of $1500 twice a year or $3000 a year (3% of $100,000). Pretty simple stuff.
The upside to this is that since these are the most highly rated bonds in the world, it is more likely than any other bond to pay you $3000 a year for 30 years ($90,000 total) and to return the principal amount at the end of the bonds term in full ($100,000). In 30 years we almost doubled our money in a “safe” way.
The downside of this is that the initial investment and interest payments are set to a fixed price. There is no such thing as compounded interest in fixed income like there would be in stocks for example. While in this case, it takes 30 years to almost double our money, in a 10 year period of compounding a 7% gain year over year in stocks would double your money. Doing that for 30 years would double your money three times. Much better returns and 7% is not out of the question for anyone.
How do Bonds Generate Income For Investors? Price Appreciation!
This is usually the part that people are the least familiar with…but have no fear. Bonds are not just a long term commitment where you HAVE to lock up your money for the full maturity of the bond. In many cases, fixed income holders (bond holders) do not hold the bonds until maturity. It is simple to get rid of a bond you may have as the bond market has massive liquidity. We are talking trillions of dollars here. Interest rates and bond prices have an inverse effect. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.
Interest rates and bond prices have an inverse effect. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. If this second example occurs where interest rates are going down, investors sometimes choose to sell the bond as the value of the bond has increased or appreciated. All the while, the bond holder was collecting its yield payments and when the value of the bond rose enough because interest rates went down enough, the bond holder sold the bond for a profit. Again, easy to do because of the insane liquidity in the bond market. In most cases, because bonds are more long term, the tax on the appreciation of the value of the bond is taxed at long-term capital gains as it is very common to hold a bond for over a year.
So…how do bonds generate income for investors? C’mon…you can answer this…
First, they pay a yield for the debt obligation.
Second, they can appreciate in value if interest rates go down.
Now the example in this post spoke about the US 30 Year Treasury Bond that yields 3%. There are bonds out there such as corporate bonds or municipality bonds or insurance bonds that do yield higher. However, the higher the interest rate, the lower the bond rating and thus the lower chance of ever seeing your initial investment back in full at the time the bond expires…if you make it there.