Bonds Definition: What are bonds and how do they work?

Home » Bonds Definition: What are bonds and how do they work?

So, the big question is, what are bonds?

Bonds are loans granted to governments or companies that in most cases pay back a fixed rate of return. They are also known as fixed income instruments, being a safer alternative to investing in stocks. Thus, bonds represent a key asset in any balanced investor portfolio.

Generally, when the stock market is going down, bond prices go up, as they are more demanded from investors that want to avoid market turbulence.

Table of Contents

How Do Bonds Work?

Bonds Key Terms

Advantages

Disadvantages

Bond Categories

Varieties of Bonds

How do bonds work?

When a borrower issues a bond to raise money, investors take a look at the following aspects: coupon rate, maturity, credit risk, and face value.

For example, a GBP 10,000 bond with a 5-year maturity and a coupon rate of 4% will pay GBP 400 a year for 5 years. After 5 years (maturity date) it will also pay back the principal, GBP 10,000. As a result, the investor will receive a steady flow of money through this period. As we will further discover, trading bonds is not as simple as it looks.

Bonds Key Terms

Coupon

The interest rate that is paid by the bond. Generally, it does not change after the security was issued. Most of the times, interest is paid once a year, but in some cases, it can be paid semi-annually or quarterly. For example, a bond with a face value of USD 1000 that has a coupon rate of 10% (always expressed in percentages) and one payment term, will pay interest of USD 100 once a year.

Yield

It is the return that an investor makes from a bond. One of the easiest ways to calculate a bond’s yield is to divide the coupon payment to the current price of a bond. For example, a bond that has a coupon payment of USD 50 and trades on the secondary market with USD 1100, has a yield of 4.5%. For bonds on the primary market, it is easier to take the coupon as the yield.

Face value

The price that an investor pays for the bond when bought from the primary market. It is also known as ‘face value’.  This value is also used when calculating the coupon price and the amount of money received when the bond matures.

Price

This is the amount at which the bond can be currently bought from the secondary market. There are a few factors that can influence its price, such as lower interest rates (trade at a premium because of the higher demand) or the change of its credit rating (if this is deteriorating, it will trade at a discount, and vice-versa).

Maturity

The length of time until the maturity date. At the maturity date, the bond issuer pays the bondholder the face value of the asset. The time frame can be as short as a few years, to going on forever in the case of perpetual bonds. Sometimes, at maturity, also the coupon is paid, for zero-coupon bonds.

Advantages

Income

Bonds offer a regular and predictable income through their coupon payments and principal payment at maturity. Investors that are looking for a stable passive income can consider buying bonds.

Profit on resale

Bonds can be sold on the secondary markets at a profit. This can happen especially if they have a higher coupon rate than other similar fixed income securities.

Safer than stocks

Bonds are safer than stocks as bond issuers pay the interest and principal on a predefined schedule. However, this happens only as long as the issuer has the resources to do so. In the case of company liquidation, bondholders are better protected than stockholders, as they are paid before them.

Tax exceptions

Some municipal and government-issued bonds have tax reductions or tax exceptions for the income earned through bonds. Thus, when calculating their yield and comparing to other tradable assets, one must take into account this benefit.

Disadvantages

Low interest rates

As bonds are a defensive asset, they pay lower returns as compared to stocks. However, over a long period of time, the return obtained from investing in stocks is higher. Thus, younger investors can consider investing in stocks rather than bonds, as they have the time to enjoy the higher returns at retirement.

Credit risk

Before buying bonds, an investor must check the bondholders’ credit risk. This is assessed generally by the Big Three credit rating agencies: Moody’s, Fitch, and Standard & Poor’s. As a result, traders must carefully watch in what bonds they invest, to be certain that they will receive the promised interest and principal payments.

Liquidity risk

As compared to blue chip stocks, bond liquidity can be substantially smaller. As a result, after purchasing them it can be challenging to sell the bonds at a fair price. In order to overcome this risk, investors can consider buying and keeping their bonds until they mature.

Inflation risk

Inflation represents an upward movement in the prices of goods and services. Thus, it is reducing the purchasing power of the bonds that offer fixed interest. For example, if a GBP bond has a 2% coupon, and the inflation in the UK is 3%, the investor will incur a net loss at the end of the year.

Call risk

This risk can arise when there are lower interest rates available for the bond issuer. As a result, the issuer will want to benefit from the reduced financing costs and retire the bond before maturity.

Bond categories

Corporate bonds

These types of bonds are issued by public and private corporations. Firms prefer to finance themselves this way as they benefit from lower interest payments and better credit conditions than banks can offer. In addition, this is a way to finance large acquisitions and investments, without the need to borrow from several lenders.

Municipal bonds

These debt securities are offered by municipalities, cities, counties, and states. Financing from these bonds is mostly used for local investments, such as building hospitals, schools, sewer systems, and infrastructure. They differ from corporate bonds as sometimes the income generated by them is tax-free. Additionally, the interest offered is higher than with government-issued bonds, but they carry more risk.

Government bonds

These securities are offered by national governments and are also known as sovereign debt. This type of bond is considered to be one of the less risky available, as it carries the creditworthiness of the issuing country. Government bonds are mostly used to raise capital or to pay outstanding debt. For example, US Treasury debt obligations are issued by the US government and are considered to be the safest asset available for purchase.

High yield bonds (junk bonds)

Are bonds below investment grade, where the issuer has a higher risk of not paying interest and capital. Thus, it has to pay investors a premium to attract them to buy the bonds. Many emerging economies are in this situation, for example, 10 years maturity bonds issued by Brazil have a 6.8% yield, while the 10-year US have a 0.7% yield.

Varieties of bonds

Fixed-rate bonds

This is the most issued type of bonds. It has a coupon rate that remains fixed until the security reaches its maturity date.

Zero-coupon bonds

This type of bond does not make any coupon payments until maturity when both principal and interest are paid. As a result, they are sold at a substantial discount from their face value.

Convertible bonds

This type of security allows bondholders to exchange a bond to a predefined number of shares. As a result, they are known as hybrid securities, combining both debt and equity elements.

Perpetual bonds

This type of bond does not have a maturity date. As a result, they are called ‘perpetuities’ by financial analysts. This type of bond will pay interest forever, while never paying back the principal. A famous example of perpetuities still active are the British World War I bonds, issued in 1917.

Callable bonds

This type of bond can be ‘called’ by the issuer before its maturity date. A company can choose to add this option when issuing bonds for two main reasons: it predicts that its credit rating will improve, and the interest rates are estimated to go down. As a result, the company will wish to call (buy) the bonds back and issue new ones with a lower coupon rate, taking advantage of the lower financing costs.

Floating rate notes

In this type of instrument, the coupon rate is variable. In many cases, it is linked to a reference rate of interest, such as Euribor or Libor. Therefore, the coupon is defined as the reference rate plus a fixed rate. For example, the interest can be composed from 3 months Euribor rate plus 0.5%.

Puttable bonds

Puttable bonds give bondholders the right to put or sell the instrument back to the bond issuer before its maturity date. This type of bond usually trades at a premium as compared to others with identical risk, coupon rate and maturity. It is more expensive as it offers investors the assurance that their asset can be bought at face value anytime.

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References:

https://www.investopedia.com/terms/b/bond.asp
https://en.wikipedia.org/wiki/Bond_(finance)
https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds
https://investor.vanguard.com/investing/investment/what-is-a-bond
https://www.fidelity.com/fixed-income-bonds/individual-bonds/overview
https://www.thebalance.com/what-are-bonds-and-how-do-they-work-3306235
https://www.nerdwallet.com/blog/investing/what-is-a-bond/
https://moneysmart.gov.au/investments-paying-interest/bonds
https://www.investopedia.com/terms/b/bond-yield.asp
https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products-0
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
https://tradingeconomics.com/brazil/government-bond-yield
https://www.investopedia.com/ask/answers/09/corporate-liquidation-unpaid-taxes-wages.asp
https://www.bbc.com/news/10108284
https://www.investopedia.com/articles/bonds/09/history-credit-rating-agencies.asp
https://www.theguardian.com/business/2014/oct/31/uk-first-world-war-bonds-redeemed

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