A bond is a certificate evidencing a debt on which the issuer promises to pay the holder a specified amount of interest based on the coupon rate, for a specified length of time, and to repay the loan at maturity. Strictly speaking, assets are pledged as security for a bond issue, except in the case of government “bonds”, but the term is often loosely used to describe any funded debt issue.
When an investor buys a bond, they are lending money to the issuer in exchange for periodic interest payments and the return of the bond’s face value when it matures. Bonds are issued with a fixed face value and a stated interest rate, which is known as the coupon rate. The issuer of the bond is obligated to make periodic interest payments to bondholders, usually semi-annually, until the bond matures. At maturity, the issuer must repay the bond’s face value to the bondholder.
Bonds can be issued by corporations, governments, and other organizations to raise capital for various purposes, such as funding new projects, expanding operations, or refinance existing debt. By investing in bonds, investors can earn a fixed income and diversify their investment portfolios. The risk associated with bonds is related to the creditworthiness of the issuer. Bonds issued by highly rated companies and governments are considered to be low risk, while bonds issued by lower-rated entities carry higher risks of default. The interest rate on a bond also reflects its perceived risk, with higher-risk bonds generally paying higher interest rates to compensate investors for the increased risk.
How Do Bonds Work?
Bonds are debt instruments representing loans made to the issuer, allowing individual investors to act as lenders. Governments and corporations use bonds to raise funds for infrastructure projects like roads, schools, and dams. Corporations may also issue bonds to finance business growth, property acquisitions, equipment purchases, R&D, or hiring employees. As fixed-income securities, bonds are a primary asset class for individual investors, alongside equities and cash equivalents. When a borrower issues a bond, it includes the loan terms, interest payments, and the maturity date when the principal is due. The interest payment, known as the coupon rate, is the return bondholders earn for lending their funds.
Bonds typically start at a par value of $1,000 per bond. The actual market price depends on the issuer’s credit quality, time until expiration, and the coupon rate relative to prevailing interest rates. The face value is repaid to the lender at maturity. Bonds can be traded in the market, allowing investors to sell them before maturity.
Characteristics of Bonds
- Face Value or Par Value: The value of the bond at maturity and the reference amount for calculating interest payments
- Coupon Rate (Yield): The interest rate paid by the issuer on the bond’s face value.
- Coupon Dates: The dates when interest payments are mad
- Maturity Date: The date when the bond matures, and the face value is repaid
- Issue Price: The price at which the bond is originally sold, often at par
Bond Categories
- Corporate Bonds: Issued by companies seeking debt financing with favorable terms and lower interest rates than bank loans.
- Municipal Bonds: Issued by states and municipalities, sometimes offering tax-free coupon income.
- Government Bonds: Issued by the U.S. Treasury, with varying names depending on maturity length: “Bills” (up to 1 year), “Notes” (1–10 years), and “Bonds” (over 10 years). Collectively known as “treasuries.”
- Agency Bonds: Issued by government-affiliated organizations like Fannie Mae or Freddie Mac
- Strip Bonds: You’ll receive the predetermined interest payments associated with a given bond
Bond Prices and Interest Rates
Bond prices fluctuate based on supply and demand. Holding a bond to maturity ensures repayment of the principal plus interest. However, bonds can be sold on the open market, where prices vary inversely with interest rates. If interest rates rise, bond prices fall, and vice versa.
A fixed-rate bond pays a coupon based on its face value. For example, a $1,000 bond with a 10% annual coupon pays $100 yearly. If market interest rates are also 10%, investors are indifferent between this bond and others offering the same return. However, if rates drop to 5%, the bond’s price will rise to equalize the yield, and if rates rise to 15%, the price will fall.
Yield-to-Maturity (YTM)
YTM is the total return expected on a bond if held to maturity, expressed as an annual rate. It accounts for the bond’s coupon rate and its price changes due to interest rate fluctuations. The modified duration measures how much a bond’s price changes with a 1% interest rate change. Bonds with longer maturities and lower coupons are more sensitive to rate changes.
How To Invest in Bonds
Investors can buy bonds through online brokers, financial institutions, or directly from the government via Treasury Direct. Bonds can also be purchased indirectly through fixed-income ETFs or mutual funds. If you buy and sell bonds, you’ll need to keep in mind that the price you’ll pay or receive is no longer the face value of the bond. The bond’s susceptibility to changes in value is an important consideration when choosing your bonds.
Bond Variations
- Zero-Coupon Bonds: Sold at a discount and pay no periodic interest, providing a return at maturity.
- Convertible Bonds: Can be converted into stock based on specific conditions.
- Callable Bonds: Can be redeemed by the issuer before maturity, posing higher risk to investors.
- Puttable Bonds: Allow bondholders to sell the bond back to the issuer before maturity.
Determining a Bond’s Coupon Rate
A bond’s coupon rate is influenced by the issuer’s credit quality and the bond’s time to maturity. Poor credit ratings and longer maturities typically result in higher interest rates due to increased risk.
Bond Ratings
Credit rating agencies like Standard & Poor’s, Moody’s, and Fitch assess the creditworthiness of bonds. “Investment grade” bonds are highly rated and stable, while “high yield” or “junk” bonds carry higher default risk but offer higher returns. If the rating is low—”below investment grade”—the bond may have a high yield but it will also have a risk level more like a stock. On the other hand, if the bond’s rating is very high, you can be relatively certain you’ll receive the promised payments.
Understanding Duration
Duration measures a bond’s sensitivity to interest rate changes, indicating how much its price will fluctuate with rate shifts. Because bonds with longer maturities have a greater level of risk due to changes in interest rates, they generally offer higher yields so they’re more attractive to potential buyers. The relationship between maturity and yields is called the yield curve.
Stocks vs Bonds
| Stock | Bond |
|---|---|
| Partial ownership of a company | A note that the company owes you money, plus interest |
| Often has partnership rights, including voting rights | Has no partnership rights, but has higher claim on the assets loaned |
| Can be held indefinitely; you own a stock until you decide to sell it | Has a limited term, at which point the principal amount is repaid with interest and the contract ends |
| Dividend payments are set by the company’s board of directors and is subject to change | Interest payments are known and often fixed; the company has no direct say in payments |
| Issued by public companies that meet the listing requirements of their exchanges | Issued by companies, municipalities, provincial governments, federal agencies, and other public institutions |
| Value has a risk of rising or dropping sharply depending on the market | Value remains the same as long as the company is in business |
Conclusion
Bonds are issued by governments and companies to finance projects and operations. They offer fixed interest payments, making them a reliable income source. Investors can purchase bonds through brokers or directly from the government. Buying bonds can be a relatively safe way to invest, determine your risk profile prior to investing your money.
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