Bond Basics: What Are Bonds?

Have you ever borrowed money?

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Of course you have! Whether we hit our parents we hit our parents up for a few bucks to buy candy as children or asked the bank for mortgage, most of us have borrowed money at some point in our lives.

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Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide.

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The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

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Of course, nobody would loan his or her hard-earned money to nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This “extra” comes in the form of interest payments, which are made at a predetermined rate and schedule.

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The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.

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For example, say you buy a bond with a face value of $1,000, a coupon of 8% , and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.

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Characteristics
Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.
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Face Value / Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.

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What confuses many people is that the value is not the price of the bond. A bond’s price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a discount.

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Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It’s called a “coupon” because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.

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As previously mentioned, most bonds are pay interest every sixmonths, but its possible for them to pay monthly, quarterly, or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it’ll pay $100 of interest a year.

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A rate that stays as fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.

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You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.

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Maturity
The maturity date is the date in the future on which the investor’s principal will be repaid. Maturities can range from as little as one day to as long as 30 years (through terms of 100 years have been issued).

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A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

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Issuer
The issuer of a bond is a crucial factor to consider, as the issuer’s stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small – so small that U.S government securities are known as risk-free assets.

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The reason behind this is that a government will always be able to bring in future revenue through taxation. This added risk means corporate bonds must offer a higher yield in order to entice investors – this is the risk/return trade off in action.