Loading the player...

What is a 'Bond'

A bond is a fixed income 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 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 that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date). The interest rate, called the coupon rate or payment, is the return that bondholders earn for loaning their funds to the issuer.

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.

Are you ready to invest in bonds? Pick the right broker by reading Investopedia's broker reviews.

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, the bondholder will be credited $50 in interest income annually. The bondholder would be indifferent to purchasing the bond or saving the same money at the prevailing interest rate.

However, if interest rates in the economy drop to 4%, the bond will continue paying 5% coupon rates, making it a more attractive option. Investors will purchase these bonds, bidding the price up to a premium until the effective rate of 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. For example, say an investor purchases a bond at a premium $1,090 and another purchases the same bond at a discount $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
  • Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
  • Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon payments.
  • 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. In addition, bonds with a high default risk, such as junk bonds, have higher interest rates than stable bonds, such as government bonds.

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 issuer 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 the 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 and a face value that is paid immediately on the maturity date.

RELATED TERMS
  1. Straight Bond

    A straight bond is a bond that pays interest at regular intervals, ...
  2. Put Bond

    A put bond is a bond that allows the bondholder to force the ...
  3. Bond Fund

    A bond fund is a fund invested primarily in bonds and other debt ...
  4. Coupon Rate

    Coupon rate is the yield paid by a fixed income security, which ...
  5. Bond Market

    The bond market is the environment in which the issuance and ...
  6. Bond ETF

    Bond ETFs are very much like bond mutual funds in that they hold ...
Related Articles
  1. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Investing

    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.
  3. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  4. Investing

    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.
  5. Investing

    Simple Math for Fixed-Coupon Corporate Bonds

    A guide to help to understand the simple math behind fixed-coupon corporate bonds.
  6. Investing

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
RELATED FAQS
  1. What determines bond prices on 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 >>
Hot Definitions
  1. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  2. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  3. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  4. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  5. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  6. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
Trading Center