What Is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.
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.
- Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
- A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.
- Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.
- Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.
How Bonds Work
Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents. (For related reading, see "Cash vs. Bonds: What's the Difference?")
Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.
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. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
The initial price of most bonds 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: 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. The face value of the bond is what will be paid back to the borrower once the bond matures.
Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
- Face value is the money amount the bond will be worth at maturity; it 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 investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
- The 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. Payments can be made in any interval, but the standard is semiannual payments.
- The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
- The issue price is the price at which the bond issuer originally sells the bonds.
Two features of a bond—credit quality and time to maturity—are the principal determinants of a bond's coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.
Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings. The very highest quality bonds are called “investment grade” and include debt issued by the U.S. government and very stable companies, like many utilities. Bonds that are not considered investment grade, but are not in default, are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.
Bonds and bond portfolios will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called “duration”. The use of the term duration in this context can be confusing to new bond investors because it does not refer to the length of time the bond has before maturity. Instead, duration describes how much a bond’s price will rise or fall with a change in interest rates.
The rate of change of a bond’s or bond portfolio’s sensitivity to interest rates (duration) is called “convexity”. These factors are difficult to calculate, and the analysis required is usually done by professionals.
Categories of Bonds
There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms.
- Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.
- Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
- Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1 – 10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "treasuries." Government bonds issued by national governments may be referred to as sovereign debt.
- Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.
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. For example, the U.S. Treasury sold 26-week bills with $100 face value for $98.78 on October 18th, 2018. That equates to a total annual yield of 2.479% once the bondholder is repaid the entire $100 at the maturity date.
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.
The market prices bonds based on their particular characteristics. A bond's price changes on a daily basis, just like that of any other publicly-traded security, where supply and demand in any given moment determine that observed price. But there is a logic to how bonds are valued. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.
The price of a bond changes in response to changes in interest rates in the economy. This is due to the fact that for a fixed-rate bond, the issuer has promised to pay a coupon based on the face value of the bond – so for a $1,000 par, 10% annual coupon bond, the issuer will pay the bondholder $100 each year.
Say that prevailing interest rates are also 10% at the time that this bond is issued, as determined by the rate on a short-term government bond. An investor would be indifferent investing in the corporate bond or the government bond since both would return $100. However, imagine a little while later, that the economy has taken a turn for the worse and interest rates dropped to 5%. Now, the investor can only receive $50 from the government bond, but would still receive $100 from the corporate bond.
This difference makes the corporate bond much more attractive. So, investors in the market will bid up to the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment—in this case, the bond will trade at a price of $2,000 so that the $100 coupon represents 5%. Likewise, if interest rates soared to 15%, then an investor could make $150 from the government bond and would not pay $1,000 to earn just $100. This bond would be sold until it reached a price that equalized the yields, in this case to a price of $666.67.
Inverse to Interest Rates
This is why the famous statement that a bond’s price varies inversely with interest rates works. When interest rates go up, bond prices fall in order to have the effect of equalizing the interest rate on the bond with prevailing rates, and vice versa.
Another way of illustrating this concept is to consider what the yield on our bond would be given a price change, instead of given an interest rate change. For example, if the price were to go down from $1,000 to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).
The yield-to-maturity (YTM) of a bond is another way of considering a bond’s price. YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled. YTM is a complex calculation but is quite useful as a concept evaluating the attractiveness of one bond relative to other bonds of different coupon and maturity in the market. The formula for YTM involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:
We can also measure the anticipated changes in bond prices given a change in interest rates with a measure knows as the duration of a bond. Duration is expressed in units of the number of years since it originally referred to zero-coupon bonds, whose duration is its maturity.
For practical purposes, however, duration represents the price change in a bond given a 1% change in interest rates. We call this second, more practical definition the modified duration of a bond.
The duration can be calculated to determine the price sensitivity to interest rate changes of a single bond, or for a portfolio of many bonds. In general, bonds with long maturities, and also bonds with low coupons have the greatest sensitivity to interest rate changes. A bond’s duration is not a linear risk measure, meaning that as prices and rates change, the duration itself changes, and convexity measures this relationship.
Real World Bond Example
A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Bonds are issued by governments, municipalities, and corporations. The interest rate (coupon rate), principal amount and maturities will vary from one bond to the next in order to meet the goals of the bond issuer (borrower) and the bond buyer (lender). Most bonds issued by companies include options that can increase or decrease their value and can make comparisons difficult for non-professionals. Bonds can be bought or sold before they mature, and many are publicly listed and can be traded with a broker.
While governments issue many bonds, corporate bonds can be purchased from brokerages. If you're interested in this investment, you'll need to pick a broker. You can take a look at Investopedia's list of the best online stock brokers to get an idea of which brokers best fit your needs.
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 more or less attractive compared to the prevailing interest rates.
Imagine a bond that was issued with a coupon rate of 5% and a $1,000 par value. The bondholder will be paid $50 in interest income annually (most bond coupons are split in half and paid semiannually.) As long as nothing else changes in the interest rate environment, the price of the bond should remain at its par value.
However, if interest rates begin to decline and similar bonds are now issued with a 4% coupon, the original bond has become more valuable. Investors who want a higher coupon rate will have to pay extra for the bond in order to entice the original owner to sell. The increased price will bring the bond’s total yield down to 4% for new investors because they will have to pay an amount above par value to purchase the bond.
On the other hand, if interest rates rise and the coupon rate for bonds like this one rise to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and begin selling at a discount compared to the par value until its effective return is 6%.
The bond market tends to move inversely with interest rates because bonds will trade at a discount when interest rates are rising and at a premium when interest rates are falling.