Bond

Loading the player...

What is a 'Bond'

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.

BREAKING DOWN 'Bond'

Bonds are commonly referred to as fixed-income securities and are one of the three main generic asset classes, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded on exchanges, while others are traded only over-the-counter (OTC).

How Bonds Work

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate (coupon) that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date).

The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.

Example

Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the market price of the bond will fluctuate as that coupon becomes desirable or undesirable given prevailing interest rates at a given moment in time. For example if a bond is issued when prevailing interest rates are 5% at $1,000 par value with a 5% annual coupon, it will generate $50 of cash flows per year to the bondholder. The bondholder would be indifferent to purchasing the bond or saving the same money at the prevailing interest rate.

If interest rates drop to 4%, the bond will continue paying out at 5%, making it a more attractive option. Investors will purchase these bonds, bidding the price up to a premium until the effective rate on the bond equals 4%. On the other hand, if interest rates rise to 6%, the 5% coupon is no longer attractive and the bond price will decrease, selling at a discount until it's effective rate is 6%.

Because of this mechanism, bond prices move inversely with interest rates.

Characteristics of Bonds

  • Most bonds share some common basic characteristics including:
  • Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond issuer uses when calculating interest payments.
  • Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.
  • Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon paymets.
  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds.

Two features of a bond – credit quality and duration – are the principal determinants of a bond's interest rate. If the issuer has a poor credit rating, the risk of default is greater and these bonds will tend to trade a discount. Credit ratings are calculated and issued by credit rating agencies. Bond maturities can range from a day or less to more than 30 years. The longer the bond maturity, or duration, the greater the chances of adverse effects. Longer-dated bonds also tend to have lower liquidity. Because of these attributes, bonds with a longer time to maturity typically command a higher interest rate.

When considering the riskiness of bond portfolios, investors typically consider the duration (price sensitivity to changes in interest rates) and convexity (curvature of duration).

Bond Issuers

There are three main categories of bonds.

  • Corporate bonds are issued by companies.
  • Municipal bonds are issued by states and municipalities. Municipal bonds can offer tax-free coupon income for residents of those municipalities.
  • U.S. Treasury bonds (more than 10 years to maturity), notes (1-10 years maturity) and bills (less than one year to maturity) are collectively referred to as simply "Treasuries."

Varieties of Bonds

  • Zero-coupon bonds do not pay out regular coupon payments, and instead are issued at a discount and their market price eventually converges to face value upon maturity. The discount a zero-coupon bond sells for will be equivalent to the yield of a similar coupon bond.
  • Convertible bonds are debt instruments with an embedded call option that allows bondholders to convert their debt into stock (equity) at some point if the share price rises to a sufficiently high level to make such a conversion attractive.
  • Some corporate bonds are callable, meaning that the company can call back the bonds from debtholders if interest rates drop sufficiently. These bonds typically trade at a premium to non-callable debt due to the risk of being called away and also due to their relative scarcity in today's bond market. Other bonds are putable, meaning that creditors can put the bond back to the issuer if interest rates rise sufficiently.

The majority of corporate bonds in today's market are so-called bullet bonds, with no embedded options whose entire face value is paid at once on the maturity date.

RELATED TERMS
  1. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  2. Coupon Rate

    The yield paid by a fixed income security. A fixed income security's ...
  3. Bond Discount

    The amount by which the market price of a bond is lower than ...
  4. Term To Maturity

    The remaining life of a financial instrument. In bonds, it is ...
  5. Term Bond

    Bonds from the same issue that share the same maturity dates. ...
  6. Reverse Convertible Bond - RCB

    A bond that can be converted to cash, debt or equity at the discretion ...
Related Articles
  1. Managing Wealth

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  2. Financial Advisor

    Advising FAs: Explaining Bonds to a Client

    Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
  3. Markets

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  4. Personal Finance

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  5. Managing Wealth

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  6. Markets

    Simple Math for Fixed-Coupon Corporate Bonds

    A guide to help to understand the simple math behind fixed-coupon corporate bonds.
  7. Managing Wealth

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  8. Investing

    What is a Premium Bond?

    A premium bond is one that trades above its face or nominal amount.
  9. Markets

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  10. Markets

    Using Excel PV Function to compute Bonds PV

    To determine the value of a bond today - for a fixed principal (par value) to be repaid in the future at any predetermined time - we can use an Excel spreadsheet.
RELATED FAQS
  1. What are the key factors that will cause a bond to trade as a premium bond?

    Learn about the primary factor that can cause bonds to trade at a premium, including how national interest rates affect bond ... Read Answer >>
  2. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  3. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
  4. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  5. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >>
  6. What forms of debt security are available for the average investor?

    Discover the various different types of debt securities, issued by government entities or corporations, that are available ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center