What is a Bond?

A bond is a written agreement or contract between an issuer and the holder that requires the issuer to pay the holder the bond’s par value or face value plus the stated amount of interest.

A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.

When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time.

A bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds. Bonds can be in mutual funds or can be in private investing where a person would give a loan to a company or the government.

The bond is a debt security, under which the issuer owes the holders a debt and (depending on the terms of the bond) is obliged to pay them interest (the coupon) or to repay the principal at a later date, termed the maturity date. Interest is usually payable at fixed intervals (semiannual, annual, sometimes monthly). Very often the bond is negotiable, that is, the ownership of the instrument can be transferred in the secondary market. This means that once the transfer agents at the bank medallion stamp the bond, it is highly liquid on the secondary market.

Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or short-term commercial paper are considered to be money market instruments and not bonds: the main difference is the length of the term of the instrument.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in a company (that is, they are owners), whereas bondholders have a creditor stake in the company (that is, they are lenders). Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors, in the event of bankruptcy. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks typically remain outstanding indefinitely. An exception is an irredeemable bond, such as a consol, which is a perpetuity, that is, a bond with no maturity.

What Does Bond Mean?

Typically, a bond is issued at a discount or premium depending on the market rate of interest. The bondholder pays the face value of the bond to the bond issuer. The bond is then paid back to the bondholder at maturity with monthly, semi-annual, or annual interest payments.

Companies, non-profit organizations, and government municipalities use bonds to raise funds for current operations and expansions. Since companies have several ways to finance expansions, they tend to use bond financing less regularly than government municipalities. Companies can raise funds through equity financing and traditional loans.

Bonds are investment securities where an investor lends money to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor’s money. Fixed income is a term often used to describe bonds, since your investment earns fixed payments over the life of the bond.

Companies sell bonds to finance ongoing operations, new projects or acquisitions. Governments sell bonds for funding purposes, and also to supplement revenue from taxes. When you invest in a bond, you are a debtholder for the entity that is issuing the bond.

Many types of bonds, especially investment-grade bonds, are lower-risk investments than equities, making them a key component to a well-rounded investment portfolio. Bonds can help hedge the risk of more volatile investments like stocks, and they can provide a steady stream of income during your retirement years while preserving capital.

The Issuers of Bonds

Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams or other infrastructure. The sudden expense of war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.

Key Terms for Understanding Bonds

Before we look at the different types of bonds, and how they are priced and traded in the marketplace, it helps to understand key terms that apply to all bonds:

• Maturity: The date on which the bond issuer returns the money lent to them by bond investors. Bonds have short, medium or long maturities.
• Face value: Also known as par, face value is the amount your bond will be worth at maturity. A bond’s face value is also the basis for calculating interest payments due to bondholders. Most commonly bonds have a par value of $1,000.
• Coupon: The fixed rate of interest that the bond issuer pays its bondholders. Using the $1,000 example, if a bond has a 3% coupon, the bond issuer promises to pay investors $30 per year until the bond’s maturity date (3% of $1,000 par value = $30 per annum).
• Yield: The rate of return on the bond. While coupon is fixed, yield is variable and depends on a bond’s price in the secondary market and other factors. Yield can be expressed as current yield, yield to maturity and yield to call (more on those below).
• Price: Many if not most bonds are traded after they’ve been issued. In the market, bonds have two prices: bid and ask. The bid price is the highest amount a buyer is willing to pay for a bond, while ask price is the lowest price offered by a seller.
• Duration risk: This is a measure of how a bond’s price might change as market interest rates fluctuate. Experts suggest that a bond will decrease 1% in price for every 1% increase in interest rates. The longer a bond’s duration, the higher exposure its price has to changes in interest rates.
• Rating: Rating agencies assign ratings to bonds and bond issuers, based on their creditworthiness. Bond ratings help investors understand the risk of investing in bonds. Investment-grade bonds have ratings of BBB or better.

What Are the Different Types of Bonds?

There are an almost endless variety of bond types. In the U.S., investment-grade bonds can be broadly classified into four types—corporate, government, agency and municipal bonds—depending on the entity that issues them. These four bond types also feature differing tax treatments, which is a key consideration for bond investors.

Corporate bonds

Corporate bonds are issued by public and private companies to fund day-to-day operations, expand production, fund research or to finance acquisitions. Corporate bonds are subject to federal and state income taxes.

Government bonds

U.S. government bonds are issued by the federal government. They are commonly known as treasuries, because they are issued by the U.S. Treasury Department. Money raised from the sale of treasuries funds every aspect of government activity. They are subject to federal tax but exempt from state and local taxes.

Agency Bonds

Government Sponsored Enterprise (GSEs) like Fannie Mae and Freddie Mac issue agency bonds to provide funding for the federal mortgage, education and agricultural lending programs. These bonds are subject to federal tax, but some are exempt from state and local taxes.

Municipal bonds

States, cities and counties issue municipal bonds to fund local projects. Interest earned on municipal bonds is tax-free at the federal level and often at the state level as well, making them an attractive investment for high-net-worth investors and those seeking tax-free income during retirement.

Varieties of Bonds

The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, being recalled by the issuer, or have other attributes.

Zero-coupon bonds do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. U.S. Treasury bills are a zero-coupon bond.

Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. For example, imagine a company that needs to borrow $1 million to fund a new project. They could borrow by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy bonds with an 8% coupon that allowed them to convert the bond into stock if the stock’s price rose above a certain value, they might prefer to issue those.

The convertible bond may the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

Callable bonds also have an embedded option but it is different than what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures. Assume that a company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If interest rates decline (or the company’s credit rating improves) in year 5 when the company could borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are not as valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

A Puttable bond allows the bondholders to put or sell the bond back to the company before it has matured. This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders.

The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each one is unique. There isn’t a strict standard for each of these rights and some bonds will contain more than one kind of “option” which can make comparisons difficult. Generally, individual investors rely on bond professionals to select individual bonds or bond funds that meet their investing goals.

How Are Bonds Priced?

Bonds are priced in the secondary market based on their face value, or par. Bonds that are priced above par—higher than face value—are said to trade at a premium, while bonds that are priced below their face value—below par—trade at a discount. Like any other asset, bond prices depend on supply and demand. But credit ratings and market interest rates play big roles in pricing, too.

Consider credit ratings: As noted above, a highly rated, investment grade bond pays a smaller coupon (a lower fixed interest rate) than a low-rated, below investment grade bond. That smaller coupon means the bond has a lower yield, giving you a lower return on your investment. But if demand for your highly rated bond suddenly craters, then it would start trading at a discount to par in the market. However, its yield would increase, and buyers would earn more over the life of the bond—because the fixed coupon rate represents a larger portion of a lower purchase price.

Changes in market interest rates add to the complexity. As market interest rates rise, bond yields increase as well, depressing bond prices. For example, a company issues bonds with a face value of $1,000 that carry a 5% coupon. But a year later, interest rates rise and the same company issues a new bond with a 5.5% coupon, to keep up with market rates. There would be less demand for the bond with a 5% coupon when the new bond pays 5.5%.

To keep the first bond attractive to investors, using the $1,000 par example, the price of the old 5% bond would trade at a discount, say $900. Investors purchasing the 5% bond would get a discount on the purchase price to make the old bond’s yield comparable to that of the new 5.5% bond.

Why do People Buy Bonds?

Investors buy bonds because:

• They provide a predictable income stream. Typically, bonds pay interest twice a year.
• If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.
• Bonds can help offset exposure to more volatile stock holdings.

Companies, governments and municipalities issue bonds to get money for various things, which may include:

• Providing operating cash flow
• Financing debt
• Funding capital investments in schools, highways, hospitals, and other projects

Bond Example

A bond is issued with a face value of $1000 and a coupon rate of $8. The bondholder will get $80 interest annually if nothing changes the bond will remain at its face value.

The interest rate begins to decrease, and the company issues a similar bond with a face value of $1000 and a coupon rate of $5. The bondholder will get $50 of interest annually, making the initial bond more valuable. The investors would want the higher interest rate bonds, they will have to pay extra to convince a current bond owner to sell their bonds. New investors will pay an amount above the face value to purchase the initial bonds, raising the price of the bond and thus decreasing the yield of the bond

If the interest rate rises from 8% to 10% then 8% coupons are no longer attractive to buyers. This will decrease the bonds price and the bond will be sold at a discounted price.

What are the Benefits and Risks of Bonds?

Bonds can provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity.

The interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.

As with any investment, bonds have risks. These riskes include:

Credit risk.  The issuer may fail to timely make interest or principal payments and thus default on its bonds.

Interest rate risk. Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.

Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.

Liquidity risk. This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.

Call risk. The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.

The pros and cons of bonds

Pros

Bonds can create a balancing force within an investment portfolio: If you have a majority invested in stocks, adding bonds can diversify your assets and lower your overall risk. And while bonds do carry some risk (such as the issuer being unable to make either interest or principal payments), they are generally much less risky than stocks.

Bonds pay interest at regular, predictable rates and intervals. For retirees or other individuals who like the idea of receiving regular income, bonds can be a solid asset to own.

Cons

Unfortunately, with safety comes lower interest rates. Long-term government bonds have historically earned about 5% in average annual returns, while the stock market has historically returned 10% annually on average.

Even though there is typically less risk when you invest in bonds over stocks, bonds are not risk-free. For example, there is always a chance you’ll have difficulty selling a bond you own, particularly if interest rates go up. The bond issuer may not be able to pay the investor the interest and/or principal they owe on time, which is called default risk. Inflation can also reduce your purchasing power over time, making the fixed income you receive from the bond less valuable as time goes on.

What Bonds Say About the Economy

Since bonds return a fixed interest payment, they look attractive when the economy and stock market decline.9 When the business cycle is contracting or in a recession, bonds are more attractive.

Bonds and the Stock Market

When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops. Borrowers must promise higher interest payments to attract bond purchasers. That makes them counter-cyclical. When the economy is expanding or at its peak, bonds are left behind in the dust. The average individual investor should not try to time the market.

When bond yields fall, that tells you the economy is slowing. When the economy contracts, investors will buy bonds and be willing to accept lower yields just to keep their money safe. Those who issue bonds can afford to pay lower interest rates and still sell all the bonds they need. The secondary market will bid up the price of bonds beyond their face values. The interest payment is now a lower percentage of the initial price paid. The result? A lower return on the investment, hence a lower yield.

Bonds and Interest Rates

Bonds affect the economy by determining interest rates. Bond investors choose among all the different types of bonds. They compare the risk versus reward offered by interest rates. Lower interest rates on bonds mean lower costs for things you buy on credit. That includes loans for cars, business expansion, or education. Most important, bonds affect mortgage interest rates. Lower mortgage rates mean you can afford a bigger house.