Bonds: What They Are & How They Work
Bonds are a security that represents a loan from an investor to a company or government agency. Learn more about the pros, cons, types or bonds, and how they differ from stocks.
What Is a Bond?
Bonds are essentially loans made by an investor to a company or government. A bond is similar to an I.O.U. and includes details about interest rates, payment dates, and other terms. The borrower agrees to pay back the loan on a particular date in the future and make coupon payments throughout the life of the loan, usually twice a year.
Tip: Basic bonds feature regular interest payments and a maturity date.
Bond Terms to Know
Investors should learn the meanings of several terms before investing in bonds.
- Face value: indicates how much the bond will be worth when it reaches maturity. It is the principal value of the bond, which means it indicates how much the bondholder will receive on the date when it fully matures, if the issuer doesn't call the bond or default on it.
- The Coupon rate: essentially represents the amount of interest payable on the bonds. The Coupon rate is calculated by dividing the total of one year's worth of coupon payments by the par value of the bond.
- Coupon date: the date(s) on which the company or government issues coupon payments to bondholders.
- Maturity date: the date when the bond is supposed to be paid off, assuming no extraordinary circumstances.
- Issue price: the price at which the bond was originally issued, which is usually the same as face value, but not always.
- Yield (yield to maturity): the effective interest rate earned by buying the bond today and holding it through to maturity. If the bond price drops, the yield increases (since the bond's return is measured against a lower current bond value), and vice versa.
- Junk bond: a bond that has been given a low credit rating by a ratings agency like Standard and Poor's. Junk bonds are also called high-yield bonds because they usually have higher yields than investment-grade bonds that possesses a higher credit rating. They are riskier than investment-grade bonds, which is why they have a higher yield.
How Do Bonds Work?
Companies or governments issue bonds when they want to raise money to finance new projects, maintain operations, or refinance maturing bonds. It's basically a loan, so when investors buy a bond, they are lending money to the company or government that issued it. Each bond comes with a maturity date and interest payments terms.
The interest payment is generally referred to as the coupon, and longer-term bonds usually pay higher coupons due to the increased length of the lending commitment. Bonds are usually traded over-the-counter (OTC), and they have a face value, also called par value. When a bond is trading for less than the face value, it's said to be selling at a discount. When a bond is trading for a price above face value, it's said to be trading at a premium.
When bonds are issued, the price is generally set at par value. As time passes, the fair value that investors assign to bonds prices will change, and the primary driver of these price movements are shifts in interest rates. There's an inverse relationship between interest rate movements and bond prices. If interest rates increase, bond prices will generally decline. If interest rates decrease, bond prices will generally rise.
Other factors, like changes in credit quality, also affect the price investors are willing to pay for a bond. If a certain bond issuer receives a credit rating upgrade, investors will usually be willing to pay a higher price for a specific bond from that issuer than before, since the assessed risk is less. This will usually cause the bond price to rise. On the flip side, where there's a credit rating downgrade, investors will deem the bonds from that issuer as more risky, and will demand a higher potential return. This will usually cause the bond price to drop, since the risk of owning a bond that's been downgraded is higher.
Some bonds are callable, which means the company or government can repay them before they reach maturity, usually at a specified price. Other bonds are putable, which means the bond holders can force the issuer to repurchase the bonds at a specified price.
Interest Rate vs. Bond Price Example
To understand the inverse relationship between bond values and interest rates, consider a bond with a face value of $1,000 that was issued when interest rates stood at 4%. This would imply that $40 in coupons (4% of $1000) will be paid to the bond owner annually. If interest rates subsequently rose from 4% to 5%, a new investor could now earn $50 of annual coupons on a new $1,000 face value bond of the same maturity. As a result, the earlier bond that pays only $40 in annual coupons looks much less attractive than the one that pays $50 in annual coupons. For this reason, investors would no longer be willing to pay $1,000 for the bond that pays only $40 annually. Instead, they would demand a lower price for that less appealing bond.
What Is the Difference Between Stocks & Bonds?
A bond is a type of investment, similar to a stock. A stock, unlike bonds, represents a tiny piece of a company, and the value of that company essentially has no limit. Bonds typically represent a loan to a company or government. Bondholders typically receive predetermined payments, unless the coupon rate is floating, and a known maturity value. On the other hand, stockholder returns are less certain, and vary substantially in price depending on the financial success of the company.
Risk & Volatility
Stocks are generally riskier and more volatile than bonds, which makes sense given that bonds tend to have prescribed returns, whereas ownership of a corporation itself is subject to a lot of upside potential and downside risk. Equity investors actively price in the upside potential or downside risk of a stock whenever markets are open, which can lead to a lot of volatility especially when expectations are changing. It's also important to know that in cases where a company becomes insolvent, the debt holders have priority claims and will be paid before equity holders.
Coupon Payments vs. Dividends
Most bonds come with semi-annual coupon payments, although they can have payments once a year, once a quarter or even monthly. On the other hand, stocks can pay dividends, and usually on a quarterly basis, although not all stocks pay dividends.
Lifecycle of a Stock vs. a Bond
When the bond matures, the issuer pays the principal back to the bondholder. However, stocks often trade in perpetuity unless the company buys back the shares, or the company is subject to a takeover offer.
Types of Bonds
There are several types of bonds available, including:
- Municipal bonds
- Government bonds
- U.S. Treasury bonds
- Savings bonds
- Corporate bonds
- Agency bonds: issued by a government-sponsored enterprise or federal government department instead of the Treasury
- Zero-coupon bonds: do not pay interest but trade at a deep discount instead, resulting in a profit at maturity
- Convertible bonds: can be converted to stock
- Callable and puttable bonds: come with an embedded put option, which gives bondholders or the company the option to close out the position prior to maturity.
Pros & Cons of Investing In Bonds
As with all investment types, there are advantages and disadvantages to investing in bonds.
Pros of Bonds
- Diversification: They can add diversification to a portfolio and are safer and less volatile than some other investments.
- Interest: Bonds offer regular interest income and thus are frequently recommended to retirees who depend on interest income for living expenses.
- Bond prices can increase: This can happen sometimes due to safe-haven buying.
Note: Not all bonds carry the same risk. Corporate bonds are riskier than government bonds, although there is a range of risks within corporate bonds as well.
Cons of Bonds
- Interest rates changes, making some bonds less valuable.
- Subject to volatility in market risk and credit risk.
- Bond prices are inversely correlated with interest rates. There is always a chance that the bonds an investor holds will decrease in price, and that companies may call their bonds in when interest rates fall to secure a more attractive rate for themselves on a new bond issue.
Tip: One of the biggest benefits of bonds is that they make regular interest payments.
What To Consider Before Buying Bonds
When considering which bonds to buy, investors should assess whether the borrower is likely to be able to pay back the money with interest. Investors frequently look at the credit quality of the issuer. Moody's, Fitch, and Standard & Poor's are the three big credit ratings agencies. AAA is the highest rating, and there is a multitude of ratings lower from there, similar to school grades.
Investors should always consider whether it's a good time to buy bonds. Bonds are an important part of diversification, so investors might want to have some in their portfolios most of the time. However, investors may wish to be cautious about new portfolio additions if bonds are in a bear market.
How To Buy Bonds
Investors can buy bonds via an online broker from investors wanting to sell. It may be possible to get a discount from the bond's face value by purchasing it directly from the investment bank that's underwriting an initial bond offering. Investors can also gain exposure to bonds via a mutual fund or exchange-traded fund that invests solely in bonds. Finally, bonds can be bought directly from the government via the Treasury Direct website.
How to Calculate Bond Yield
To calculate a bond's yield, investors divide the annual coupon payment by the price of the bond.
Bond Yield = annual coupon payment / price of the bond
The yield changes whenever the price the bond is selling for changes. For example, if an investor buys a bond at par value for $1,000, and the bond pays $100 per year for 10 years, the yield in this scenario is 10%. However, if the investor sells the bond for $800, the effective yield increases to 12.5%. (=$100/$800)
Should You Invest In Bonds?
As with all investments, investors should consider the risks of investing in bonds and weigh them against the potential rewards. Bonds are usually an important part of a diversified portfolio. On one hand, bonds provide steady payments and are less risky than some other investments like stock. On the other hand, bonds face interest rate risk, inflation risk, and reinvestment risk.
Note: This report is purely for educational purposes and not a recommendation to buy or not buy bonds.
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