What is the definition of a bond?
A bond is a fixed-income security that represents an investor’s debt to a borrower (typically corporate or governmental). A bond can be regarded of as a promissory note between the lender and the borrower that outlines the loan’s terms and installments. Companies, municipalities, states, and sovereign governments all use bonds to fund projects and operations. Bondholders are the issuer’s debtholders, or creditors.
The end date when the principal of the loan is scheduled to be paid to the bond owner is normally included in the bond specifics, as are the terms for the borrower’s variable or fixed interest payments.
Important Points to Remember
- Bonds are units of corporate debt that are securitized as tradeable assets and issued by firms.
- A bond is referred to as a fixed-income instrument since it pays debtholders a fixed interest rate (coupon).
- Variable or floating interest rates are becoming increasingly popular.
- Interest rates and bond prices are inversely related: as rates rise, bond prices fall, and vice versa.
- Bonds have maturity dates after which the principal must be paid in full or the bond will default.
Bonds are a frequent way for governments (at all levels) and enterprises to borrow money. Roads, schools, dams, and other infrastructure must be funded by governments. The unexpected cost of war may necessitate the need to raise finances.
Similarly, firms frequently borrow to expand their operations, purchase real estate and equipment, embark on profitable ventures, conduct research and development, or hire new staff. The issue that large organizations have is that they frequently require significantly more funds than the normal bank can supply.
Bonds offer a solution by allowing a large number of individual investors to act as lenders. Thousands of investors can each contribute a share of the required funds through public debt markets. Furthermore, markets enable lenders to sell their bonds to other investors or buy bonds from other individuals long after the original issuer has raised funds.
Bonds and How They Work
Bonds, also known as fixed-income instruments, are one of the most common asset classes that individual investors are familiar with, alongside stocks (equities) and cash equivalents.
Many corporate and government bonds are exchanged on the open market; others are only traded over the counter (OTC) or privately between the borrower and the lender.
Companies and other entities may offer bonds directly to investors when they need money to fund new initiatives, maintain continuing operations, or refinance existing debts. The borrower (issuer) creates a bond that specifies the loan terms, interest payments, and the time frame in which the borrowed funds (bond principle) must be repaid (maturity date). The coupon (interest payment) is part of the return bondholders receive for lending their money to the issuer. The coupon rate is the interest rate that affects the payment.
The starting price of most bonds is usually fixed at par, or $1,000 per bond’s face value. The real market price of a bond is determined by a number of factors, including the issuer’s credit quality, the length of time until expiration, and the coupon rate in comparison to the current interest rate environment. The face value of the bond is the amount that the borrower will receive when the bond matures.
After they’ve been issued, most bonds can be sold to other investors by the original bondholder. To put it another way, a bond investor is not required to retain a bond until it matures. Bonds are frequently repurchased by the borrower when interest rates fall or the borrower’s credit improves, allowing it to release new bonds at a lower cost.
Most alliances have certain basic traits in common, such as:
The face value of a bond is the amount of money it will be worth at maturity; it is also the amount used by the bond issuer to calculate interest payments. For example, suppose one investor buys a bond at a premium of $1,090, and another investor buys the identical bond at a discount of $980 later. Both investors will receive the bond’s $1,000 face value when it matures.
The coupon rate is the percentage rate of interest that the bond issuer will pay on the bond’s face value. A 5% coupon rate, for example, means that bondholders will get 5% x $1000 face value = $50 per year.
The bond issuer’s coupon dates are the dates on which interest will be paid. Payments can be made at any time, however semiannual payments are the most common.
The bond will mature on the maturity date, and the bond issuer will pay the bondholder the face amount of the bond.
The issue price is the price at which the bond issuer sells the bonds for the first time.
Credit quality and time to maturity are the two main factors that influence a bond’s coupon rate. The danger of default is higher if the issuer has a low credit rating, and these bonds pay higher interest. Bonds with a long maturity date typically pay a higher rate of interest. This higher compensation is due to the bondholder’s longer-term exposure to interest rate and inflation risks.
Credit rating firms such as Standard and Poor’s, Moody’s, and Fitch Ratings create credit ratings for companies and their bonds. The highest-quality bonds are referred to as “investment grade,” and include debt issued by the United States government as well as relatively stable enterprises such as numerous utilities.
“High yield” or “junk” bonds are bonds that are not rated investment grade but are not in default. Because these bonds are more likely to default in the future, investors expect a greater coupon payment to compensate for the risk.
As interest rates vary, the value of bonds and bond portfolios will rise or fall. The term “duration” refers to a person’s sensitivity to interest rate increases. New bond investors may be perplexed by the use of the term duration in this context because it does not refer to the length of time until the bond matures. Instead, duration refers to how much the price of a bond will grow or fall in response to a change in interest rates.
Convexity refers to the rate of change in a bond’s or a bond portfolio’s interest rate sensitivity (duration). These are difficult to compute, and the necessary analysis is normally performed by professionals.
Bonds are divided into several categories.
In the bond market, there are four main types of bonds. On some sites, however, you may find foreign bonds issued by firms and governments.
Corporations issue corporate bonds. In many circumstances, companies issue bonds instead of seeking bank loans for debt financing because bond markets provide better conditions and cheaper interest rates.
States and municipalities issue municipal bonds. Some municipal bonds provide investors with tax-free coupon income.
Bonds issued by the government, such as those issued by the United States Treasury. Bonds issued by the Treasury with a maturity of one year or less are referred to as “Bills,” notes with a maturity of one to ten years are referred to as “notes,” and bonds with a maturity of more than ten years are referred to as “bonds.” The term “treasuries” is often used to refer to the entire category of bonds issued by a government treasury. Sovereign debt refers to government bonds issued by national governments.
Bonds issued by government-affiliated organizations like Fannie Mae and Freddie Mac are known as agency bonds.
Bonds Come in a Wide Range of Types
There are many different types of bonds accessible to investors. They can be distinguished by the rate or kind of interest or coupon payment, by the issuer’s recall, or by other characteristics.
Bonds with no coupon
Zero-coupon bonds do not pay coupon payments and are instead sold at a discount to their par value, generating a return when the bond expires and the bondholder receives the full face value. Treasury notes in the United States are a zero-coupon bond.
Bonds that can be converted into cash
Convertible bonds are financial securities having an inherent option for bondholders to convert their debt into stock (equity) at a later date, subject to specific circumstances such as the share price. Consider a corporation that requires a $1 million loan to develop a new project. They might borrow money by issuing bonds with a 12-percent coupon and a 10-year maturity. They would opt to issue bonds with an 8% coupon that permitted them to convert the bond into stock if the stock’s price rose above a particular value if they knew there were some investors eager to buy them.
The convertible bond could be the greatest option for the company because it would allow them to pay lesser interest payments while the project was still in its early phases. The other shareholders would be diluted if the investors converted their bonds, but the corporation would not have to pay any further interest or the bond’s principal.
Investors who bought a convertible bond could think it’s a good idea because they can profit from the stock’s upside if the project succeeds. Accepting a smaller coupon payment exposes them to higher risk, but the potential profit if the bonds are converted may make the trade-off worthwhile.
Bonds that can be called in
Callable bonds have an inbuilt option as well, although it is not the same as a convertible bond’s. A callable bond is one that the firm can “call” back before it matures. Assume a corporation has borrowed $1 million by issuing bonds with a 10% coupon and a ten-year maturity. If interest rates fall (or the firm’s credit rating improves) in year 5, when the company can borrow for 8%, the corporation will call or buy back the bonds from bondholders for the principal amount and reissue new bonds with a lower coupon rate.
Because a callable bond is more likely to be called as its value rises, it is riskier for the bond buyer. Keep in mind that as interest rates fall, bond prices climb. As a result, callable bonds with the same duration, credit rating, and coupon rate are less valued than non-callable bonds.
Bond that can be put on the market
A puttable bond is one that permits bondholders to sell or put the bond back to the company before it matures. This is useful for investors who are concerned about a bond’s value falling, or who believe interest rates will rise and wish to recover their principle before the bond drops in value.
The bond issuer may add a put option that favors bondholders in exchange for a lower coupon rate, or simply to entice bond sellers to make the initial loan. Because it is more valuable to bondholders, a puttable bond typically trades at a higher price than a bond without a put option but with the same credit rating, maturity, and coupon rate.
In a bond, the number of conceivable combinations of embedded puts, calls, and convertibility rights is infinite, and each one is different. There isn’t a set of rules for each of these rights, and some bonds will have multiple types of “options,” making comparisons difficult. Individual investors typically rely on bond professionals to help them choose individual bonds or bond funds that fit their investment objectives.
Bonds are valued in the market depending on their unique qualities. The price of a bond fluctuates on a daily basis, just like the price of any other publicly traded security, and is determined by supply and demand at any particular time.
The way bonds are valued, however, follows a logic. We’ve talked about bonds as if every investor holds them until they mature up to this point. True, you’ll get your principle back plus interest if you do this; however, a bond doesn’t have to be kept until maturity. A bondholder can sell their bonds on the open market at any moment, when the price can fluctuate substantially.
The price of a bond fluctuates in reaction to changes in the economy’s interest rates. This is because the issuer of a fixed-rate bond has committed to pay a coupon based on the face value of the bond—for example, if the bond has a $1,000 par value and a 10% annual coupon, the issuer will pay the bondholder $100 per year.
Assume that the prevailing interest rates at the time this bond is issued are also 10%, as indicated by the yield on a short-term government bond. An investor would be unconcerned whether he or she invested in a business or government bond because both would return $100. Consider what would happen if the economy had taken a turn for the worst and interest rates had plummeted to 5%. The investor can now only get $50 from the government bond, but he or she can still get $100 from the business bond.
This distinction makes the corporate bond far more appealing. As a result, market participants will bid up the price of the bond until it trades at a premium that equalizes the current interest rate environment—in this case, the bond will trade for $2,000, representing a 5% coupon. Similarly, if interest rates rose to 15%, an investor could get $150 from a government bond instead of paying $1,000 for only $100. This bond would be sold until the yields were equalized, which would be at $666.67 in this example.
Interest Rates in Opposition
This is why the well-known assertion that the price of a bond varies inversely with interest rates holds true. When interest rates rise, bond prices fall in order to bring the bond’s interest rate in line with the market rate, and vice versa.
Another approach to visualize this notion is to imagine what our bond’s yield would be if the price were to fluctuate instead of the interest rate. For instance, if the price drops from $1,000 to $800, the yield increases to 12.5 percent. This occurs because you will receive the same guaranteed $100 on an asset worth $800 ($100/$800). In contrast, if the bond’s price rises to $1,200, the yield falls to 8.33% ($100/$1,200).
Yield-to-Maturity (YTM) is a term used to describe the amount of money (YTM)
Another method to think about a bond’s pricing is to look at its yield-to-maturity (YTM). The YTM is the expected total return on a bond if it is held until the end of its life. Long-term bond yields are referred to as yield to maturity, however they are expressed as an annual rate. In other words, it is the internal rate of return on a bond investment if the holder holds the bond until it matures and makes all scheduled payments.
YTM is a complicated computation, but it’s a valuable idea for comparing the attractiveness of one bond to other bonds in the market with varied coupons and maturities. Because the YTM formula requires solving for the interest rate in the following equation, which is a difficult undertaking, most YTM bond investors will utilize a computer:
A measure known as the length of a bond can also be used to calculate the expected changes in bond prices as a result of a change in interest rates. Since term initially refers to zero-coupon bonds, whose length is their maturity, duration is represented in units of the number of years.
However, in practice, duration refers to the price change in a bond as a result of a 1% change in interest rates. This second, more practical meaning is known as the bond’s adjusted duration.
The duration can be used to estimate the price sensitivity of a single bond or a portfolio of bonds to interest rate fluctuations. Bonds with long maturities, as well as bonds with low coupons, are the most sensitive to interest rate changes in general. The length of a bond is not a linear risk measure, meaning that it fluctuates as prices and rates vary, and convexity gauges this relationship.
Example of a Bond
A bond is a guarantee from a borrower to repay a lender with the principal and, in most cases, interest on a loan. Governments, municipalities, and corporations all issue bonds. In order to achieve the aims of the bond issuer (borrower) and the bond buyer, the interest rate (coupon rate), principal amount, and maturities will change from one bond to the next (lender). Most corporate bonds come with alternatives that might boost or decrease their value, making comparisons difficult for non-experts. Bonds can be purchased or sold before they mature, and many are publicly traded and tradeable through a broker.
While governments issue a large number of bonds, brokerages sell corporate bonds. You’ll need to choose a broker if you’re interested in this investment. You can get a sense of which brokers best suit your needs by looking at investingclue’s list of the best online stock brokers.
Because fixed-rate coupon bonds pay the same proportion of their face value throughout time, the bond’s market price will fluctuate as the coupon becomes more or less appealing in comparison to current interest rates.
Consider a bond with a 5% interest rate and a $1,000 par value. An annual interest payment of $50 will be sent to the bondholder (most bond coupons are split in half and paid semiannually). The bond’s price should remain at par value as long as nothing else changes in the interest rate environment.
However, if interest rates start to fall and similar bonds with a 4% payment are released, the original bond becomes more valuable. To attract the original owner to sell, investors who desire a higher coupon rate will have to pay more for the bond. Because new investors will have to pay a sum above par value to obtain the bond, the total yield will drop to 4% as a result of the additional price.
However, if interest rates rise and the coupon rate for bonds like this one rises to 6%, the 5% coupon will no longer be appealing. The bond’s price will fall and it will begin to trade at a discount to its par value until its effective return reaches 6%.
What Are Bonds and How Do They Work?
Bonds are a sort of security that governments and enterprises sell in order to raise funds from investors. Selling bonds is thus a kind of borrowing money from the seller’s standpoint. Buying bonds is a kind of investment from the buyer’s perspective because it entitles the buyer to guaranteed principal repayment as well as a stream of interest payments. Some bonds include additional features, such as the opportunity to convert the bond into stock in the issuing corporation.
Because bonds trade at a discount when interest rates are rising and at a premium when interest rates are decreasing, the bond market moves inversely with interest rates.
What Does a Bond Look Like?
Consider the situation of XYZ Corporation as an example. XYZ wants to borrow $1 million to build a new factory but is unable to do so due to a lack of funding from a bank. XYZ instead chooses to raise funds by selling $1 million in bonds to investors. According to the bond’s conditions, XYZ will pay its bondholders 5% interest per year for the next five years, with interest paid semiannually. The bonds each have a $1,000 face value, thus XYZ is selling a total of 1,000 bonds.
What Are the Different Bond Types?
The example above is for a standard bond, however there are many different types of bonds. Zero-coupon bonds, for example, do not pay interest during the bond’s duration. Instead, their par value—the amount they return to the investor at the end of the term—is more than the amount paid when the bond was purchased.
Convertible bonds, on the other hand, allow bondholders to exchange their bonds for shares in the issuing business provided specified objectives are met. There are other more sorts of bonds available, each with its own set of benefits such as tax planning, inflation hedging, and so on.