What is a Bond?

Understanding bonds

When a company needs money or funds, they have two options: selling stocks or borrowing money. Borrowing money involves issuing bonds to investors, who then become lenders. These bond investors can sell their bonds to other investors, allowing the bonds to be traded in the market. The company is responsible for repaying the bondholder when the bond reaches maturity, and they may also make interest payments throughout the bond’s lifespan. However, it’s important to remember that if the company goes bankrupt, there’s no guarantee that the bondholder will receive their repayment.

Simple explanation

A bond is like an IOU that you can trade — but they’re not guaranteed…

When a bond is issued, it establishes a relationship between a borrower and a lender. The borrower, often a company, issues the bond, and the lender, typically an investor, buys it. Borrowers receive funds, while lenders usually receive interest payments. Nevertheless, there is a possibility that the entity issuing the bond, whether it’s a company, entity, or government, may go bankrupt, leaving the bond investor without repayment (IOU repaid).

What are the key bond terms to know?

Understanding bonds involves unraveling the terminology commonly used in relation to them. These terms are interconnected and serve as the foundation for the bond ecosystem. As you familiarize yourself with each term, you’ll notice how they all relate to one another in a “circle of life” style.

• Principal & Interest: When it comes to bonds, these are the two key financial elements to consider. The principal refers to the initial amount of money borrowed by the bond issuer (borrower), while the interest represents the fixed or variable payment made by the borrower to the bond owner (lender).
• Coupon: Another way to describe interest payments — the annual interest rate determines the amount the borrower pays the lender, who holds the bond, throughout the bond’s lifetime. Typically, these payments are made every six months.
• Maturity date: The maturity date represents the end date for the bond. The borrower is required to repay the entire borrowed amount (principal) to the bondholder.

Who issues bonds?

Bond issuers, or those looking to borrow money, are commonly divided into four main groups:

1. Corporations: Companies issue bonds to secure funds for various purposes such as funding growth initiatives, leasing new properties, acquiring other businesses, or simply increasing their cash reserves.
2. Municipal governments: Municipal bonds, also known as “munis,” are issued by local governments or US states. If you live in a particular state, buying a muni bond from your home state might offer tax benefits. This is because the interest payments on these bonds could be tax exempt.
3. Federal governments: Federal government bonds are considered very safe investments since they are backed by the “full faith and credit” of the US government. These bonds are commonly referred to as “Treasury bonds” or “Treasuries”. The money raised from selling these bonds is used to finance various government expenses like salaries, military projects, and public health programs.
4. Other institutions: Educational institutions, public transit agencies, and other organizations have the option to issue bonds in order to finance themselves for various purposes, such as expanding into new countries or constructing new offices.

Types of bonds you’ll see

Among the four types of issuers above, you’ll find a wide range of bond types. Each bond has its own unique characteristics, but it’s important to remember that all bonds come with a certain level of risk.

Convertible bonds

Convertible bonds are a type of corporate bond that gives the bondholder the option to exchange the bond for company stock at a set price. Because of this conversion option, the interest rate offered by the bond issuer is typically lower than that of a standard non-convertible bond.

Zero Coupon bonds

Zero Coupon bonds (as the name suggest) don’t pay bondholders any coupon interest. Instead, they are sold at a lower price (a discount) than their face value. This allows investors to profit from the difference between the purchase price and the repayment amount at maturity. The bond issuer doesn’t make any interest or coupon payments throughout the bond’s duration.

Callable or puttable bonds

Callable or puttable bonds offer the flexibility for the issuer or the investor to terminate them ahead of time if they wish.

• A callable bond gives the issuer the power to demand it back, or “called”, before it reaches maturity. This can be seen as a benefit for the issuer, but it does come with a cost for the bondholder. To make up for this, the issuer typically offers a higher interest rate.
• A puttable bond allow bondholders to sell the bond back to the issuer, or “put”, before the maturity date. To cover the cost to the issuer, these bonds typically come with a lower interest rate for the bondholder.

Bonds in the markets

Bonds, similar to stocks, are traded in public securities markets. When it comes to buying bonds, you can either go through a bond broker or directly purchase government bonds from government agencies. Another way to gain exposure to bonds is by investing in funds that consist of bond investments. Regardless of how you choose to access bonds, it’s important to understand their worth by considering two key factors: the price and the interest rate.

Interest rates: The primary value of owning a bond for an investor lies in the interest rate offered by the issuer. This rate is determined by the issuer’s creditworthiness, which indicates the level of risk associated with the issuer and the probability of bond repayment upon maturity. It’s important to note that riskier bonds typically come with higher interest rates.

Prices: Investors can gain from buying bonds at a lower price (discount) and receiving the full amount when it matures. The “full price”, or “face value”, is usually $1,000 for a bond. So, even if you buy a bond for $900, you can still expect to receive the full $1,000 when it reaches maturity. But if the issuer is at risk of defaulting, the $900 bond may lose value or default, resulting in missed payments to the bondholder.

Interest rates and bond prices often have an inverse relationship. Bond prices usually go down when interest rates go up and vice versa. This is because higher interest rates make the fixed interest rate (the “coupon rate”) on bonds less attractive. Investors may choose to invest in bonds with higher interest rates, resulting in a decrease in demand for lower-interest bonds and a decrease in their prices.

What are some bond risks?

Just as with stocks, there’s no guarantee of returns when investing in bonds. Bonds are viewed as less risky than stocks because bond issuers are legally required to repay bondholders, not shareholders. Investors can mitigate risk in their portfolios by diversifying with bonds and balancing their stock investments. However, bond issuers can still go bankrupt, potentially causing bondholders to lose their entire investment. While bond prices are typically less volatile than stocks, there are still risks involved. Two of the main risks are default risk and interest rate risk.

Default Risk

When a borrower (the bond issuer) fails to make the interest payments or repay the principal to the bondholder, it is called defaulting. This typically happens when the company becomes insolvent, meaning it has accumulated more debt than it can afford to pay back. Defaults are often associated with bankruptcies, which is a legal procedure to decide the fate of an insolvent company.

If a company defaults, bondholders might have an edge over other creditors, but they could also end up at a disadvantage compared to certain parties. In bankruptcy, bondholders could be first in line to receive repayment ahead of vendors, employees, and shareholders, yet they might have to wait until senior or preferred creditors are paid off. Nevertheless, in a bankruptcy scenario, bondholders still face the possibility of not being fully repaid.

Interest Rate Risk

The bond issuer pays the bondholder interest in the form of coupon payments, and the bondholder seeks the highest coupon payments possible while taking into account the bond’s risk. If interest rates increase and other companies (with similar risk levels) begin issuing bonds at higher rates, your bonds may become less appealing to investors. This could lead to a decrease in the bond’s price.

Bond rating = the bond’s risk level

If your friend asks you to pay for their brunch, you might consider whether they can pay you back. Credit rating agencies use a similar approach for bond issuers, but they typically conduct a more thorough and complex analysis to evaluate the issuer’s creditworthiness. They also publish the results of their analysis, commonly referred to as credit ratings, to assist investors in making informed decisions.
Third-party companies such as Fitch, Moody’s, or Standard & Poors generate credit ratings to analyze the financial health and creditworthiness of bond issuers. They consider various factors, but mainly focus on the issuer’s ability to pay back debts. A company with rising sales and profits is more likely to receive a higher credit rating, whereas stagnant growth could lead to a downgrade. Similarly, a country going through an economic recession is at risk of a lower government credit rating.

• Investment grade means there is a low to moderate risk of default. These are issuers rated BBB or higher for S&P and Baa or higher for Moody’s. The top grade is Aaa or AAA, which is reserved for just a few governments, companies, and other bond issuers.
• Non-investment grade means there’s a significant credit risk involved. These bonds, often referred to as “junk bonds,” are issued by companies with high levels of debt. It’s important for investors to be aware that these bonds carry a much higher risk of default. In exchange, investors typically demand higher interest rates to offset all that additional risk they’re undertaking.

Different rating agencies may have their own unique rating terms, but they all share a common goal of providing investors with insights into the risk associated with a bond, helping them make well-informed investment choices.

Are bonds “fixed income”?

Yep, that’s the fancy term you’ll often hear when people talk about bonds. You see, a lot of bonds actually pay the bondholder a regular coupon payment, which is basically a fixed amount of money. So, the bondholder gets a steady income from the company that issued the bond. This kind of investment can be pretty appealing to folks who are retired and depend on their investments to cover their expenses.

Banks on Wall Street usually have departments called “Fixed Income Divisions” that deal with trading bonds issued by companies, organizations, and governments. These divisions aim to make money by trading bonds, using different strategies to capitalize on changes in bond prices.