What is a Bond?

A bond is a fixed-income security which is essentially a loan made by an investor to a borrower, however, bonds can also be seen as an informal agreement between investors and borrowers as a way of saying “I owe you”. Bonds are used in a multitude of fields by a multitude of entities which include companies, states, municipalities, lone investors, and sovereign governments all to finance operations conducted by said entities. Those of which who own these Bonds and “issue” them are called debtholders, or creditors interchangeably. Note that bonds have details on them which often consist of the expiry date, which is when the principal of the loan is issued to be paid to the creditor. Details that follow this are often ones of which that concern the terms and conditions regarding variable or fixed interest payments that will be made by the borrower.  

The Issuers of Bonds

Typical users of bonds include the government, at all levels, and corporations. They use these bonds to both issues and borrow money, this is because even the government or corporations need to fund their operations. For example, constructing things like schools and other infrastructure might require the government to borrow money when said money is not always on hand.

Similar to governments, corporations don’t always have sufficient funds to complete or fund their operations which is what creates the need for bonds. Although, most large corporations often require way more money than any average bank can supply to them. But bonds provide a solution by allowing investors or other entities to lend out the money required by these companies or government bodies. Subsequently, it is no surprise that public debt markets allow thousands of investors to lend a portion of the amount required by other entities. Additionally, these debt markets also allow lenders to sell their bonds or acquire them from other investors or entities well after the issuer has raised the required capital.

How Bonds Work

To start, bonds can be defined as fixed-income securities and are one of the things that most investors are familiar with. Often corporate, and government bonds are publicly traded although others are traded over the counter and or privately between the borrower and the creditor.

Additionally, companies or governments will often issue bonds to raise sufficient funds for a given project, to pay debts, or fund basic operations, they might issue bonds to investors. Said borrower will issue a bond that states the terms of conditions of the loan, the interest payments that are to be paid, and the date at which the borrowed funds must be paid back in full.

Note that the interest payment or coupon tied to these Bonds is an amount that is paid to the bondholder at a given rate by the issuer for letting them loan their funds to them. This is commonly referred to as the coupon rate.

Furthermore, the subsequent price of most bonds is often set at par or $1000 per bond. Although, this is not true for all bonds and the market value is determined by several factors. These include the credit quality of the issuer (the rating of an entity’s ability to pay debt), the length of maturity date, and the coupon rate in comparison to the accepted interest at the time of issue.

Note that bonds can be resold by the initial bondholder to other investors that are willing to loan their money after it has already been issued. If a bond investor no longer wishes to issue the bond before its maturity date they can do so. This is commonly done through a process that of which the borrower will repurchase their bond of interest so that they can reissue the bond(s) at a lower price often due to declining interest rates.

Characteristics of Bonds

Bonds will rise and fall in value as generally accepted interest rates rise and fall and the likeliness of change in the interest rates is called the duration. In this context, the word duration does not refer to the length of time before the bond matures rather duration refers to how much a bond’s price will rise or fall with a change in interest rates. This rate of change in a bond’s duration is called “convexity”. Although, one should note that these factors are often not easy to calculate and require professional help.

Face Value:

Face value also known as the principal is the price said bond will be valued at when it reaches maturity although, it is also the amount used by the bond issuer used in reference to calculate the interest. For example, if an investor were to purchase a bond at a premium and another investor buys the same bond for a discount regardless of any factors when the bond matures both investors in said bond will receive the face value of $1000.

The coupon rate:

The coupon rate is the rate of interest at which the issuer of the bond will make interest payments based on the face value of the bond. This rate is measured in percentage.

Coupon dates:

Coupon dates are the dates on which the issuer will make payments at the coupon rate. These payments can be made at any time interval denoted in the terms and conditions of the bond, but often these payments are made semi-annually/every 6 months.

Maturity Date:

The maturity date is the date on which the bond issued by the issuer will mature or “expire” in which the issuer will pay the face value of a said bond.

The issue price:

The issue price is the original price at which the bond will be issued.

There are two factors of bonds that determine the coupon rate, these are the credit quality of the issuer and the bond’s time to mature. For example, if the bond issuer has a poor credit rating and is known to have a poor ability to pay back their debts the risk of default is greater which is essentially the failure of said issuer to make the required interest or principal payments are more likely to occur. This results in higher-paying interest bonds.

Bonds with long maturity periods as pay higher interest rates because the bondholder is subject to interest rates and inflation risks for a long period. However, when discussing credit ratings for issuers and their bonds they are generated/decided by credit rating industries.

Note that the highest quality bonds are called investment grade and are often issued by the US government and stable companies. On the contrary, bonds that are issued that are not investment grade but are also not default can be seen as high yield bonds as said bonds have a higher risk of default and investors often ask for higher coupon payments to compensate for said risk.

Categories of Bonds

There are four primary categories of bonds.

Corporate Bonds:

These are bonds issued by companies. Companies will seek to issue these bonds rather than take loans from banks because bond markets offer better terms and conditions at lower interest rates.

Municipal Bonds:

These bonds are issued by states and municipalities. These bonds offer tax-free coupon income for investors.

Government Bonds:

Government bonds are those of which that are issued by the government. These include Treasury Bills, Bonds, or notes which all have specified maturity dates. Other types of government-issued bonds which are issued by national governments are referred to as sovereign debt.

Agency Bonds:

These are bonds that are issued by government associated organizations.

Varieties of Bonds

Bonds that are publically available for investors come in many varieties and are separated often by their rate of interest, type of interest, when they are recalled by the issuer or other factors.

Zero Coupon Bonds:

As the name implies zero-coupon bonds do not pay coupon payments and are issued at a discount to par value that generates a return amount once the bondholder is paid the principal when the bond finally matures.

Convertible Bonds:

These bonds are debt securities with the option that allows bondholders to convert their bond into a company’s stock depending on laid out conditions like the stock price per share. Essentially, if a company wishes to issue bonds at a certain coupon rate and maturity date but they know that some investors are willing to buy other bonds with a given coupon rate which allows them to convert the bond into equity if the stock’s price rises above a given value, they might prefer said option rather than issuing a standard bond.

The convertible bond might pay lower interest rates making it the better option and if the investors converted their bonds into shares this would dilute other shareholders and would allow them to no longer have to pay any more interest or the principal of said bond. Although risky for investors, accepting a lower coupon bond at a tradeoff of being able to convert said bond into shares can be a good alternative if they indeed profit from the rise of the stock if the company’s operations are successful.

Callable Bonds:

These bonds like Convertible bonds have a nested option. A callable bond can be called back/bought back by the issuer for the principal amount before it matures. This is often done when a company’s credit rating has improved or when interest rates decline so they can issue a new bond at lower rates.

Note that callable bonds come with high risk for the buyer as the bond is likely to be called when interest rates decline and bond value increases when interest rates decline. As a result, callable bonds are not as valuable compared to those of which that are not.

Puttable Bond:

What a puttable bond does is it allows the bondholders to sell the bond back to the issuer before it matures. This is an advantage for investors that believe the bond could fall in value via rising interest rates or if they think said bond could default so they can get their principal back before they lose money in their investment. In this case, the issuer might apply a put option to the bond which benefits the bondholder in exchange for lower coupon rates or to entice investors to make the initial loan.

A puttable bond often trades at a higher value than bonds without sell options because it is more valuable to the bondholders due to their decreased risk. Moreover, there are many ways puttable bonds can be comprised as each can have an endless combination of puts, calls, and other conditions. There is no specific standard for each of these factors and some bonds might contain more or less than others. Generally, this can make deciding on what bond an investor might want to choose harder than usual, which is why investors often rely on bond professionals to select what bonds are best to meet what they want in an investment.

Pricing Bonds

Recall that the price of bonds is based on particular characteristics and prices change daily where the given price is often determined by the supply and demand at any given moment. Although, a bond’s price relies on more than just supply and demand. As discussed previously, if one as an investor is to hold their bond till maturity they will indeed receive a principal amount plus interest added on overtime. However, like publically traded security bonds can be sold at any time where the price can change drastically.

A common way this price fluctuates is in response to interest rates rising and falling in the economy. This occurs because for the fixed-rate bond the issuer has promised to pay a coupon based on the face value of the bond itself. For example, imagine an investor purchases a bond with a face value of $5000 par with a 10% annual coupon determined by short-term government bonds, in this the issuer will pay the holder $500 annually. Although imagine in 5 years the market has worsened and interest rates have dropped to 5%. Now the investor would only receive $250 from the short-term government bond, but would still receive the full $500 from a corporate bond.

This gap in revenue makes a corporate bond much more appealing to investors, enough that they will often bid on the price of a bond till it reaches a premium that will equalize the current interest rate environment. This would allow a bond to trade at $2000 which allows for a coupon worth $100 to represent the 5%. Then if interest rates were to rise the investor could make an increased amount of money on the government bond rather than paying $1000 to only make $100. Bonds like these are often sold until they reach a price that equalizes yields.

Inverse to Interest Rates

Recall that a bond’s price is the inverse of interest rates. When rates go up, bond price falls, and vice versa. This occurs to equalize the margin of profit based on prevailing interest rates on a given bond. Principally how it works is the following. The yield on a bond changes based on the price change rather than the interest rate itself. For example, if a $1000 bond decreases to $600 the yield increases 16.6% because you are still getting the same $100 interest payments on an asset that is now worth $600. Subsequently, this works the other way around as if a bond increases from $1000 to $1500 the yield decreases 0.06%.

You can see this example as the relationship between rising interest rates and bond prices. Note that when the yield goes up when the price goes down, and when the yield goes down the price goes up. This is relative to how interest rates often go higher the lower the bond price is and lower the more expensive the bond is.

Yield to Maturity (YTM)

What is YTM? Well, Yield to Maturity is another way of viewing a bond’s price and it is the anticipated return amount on a given bond if said bond is held until maturity. YTM is seen as a long-term bond yield but is seen as an annual rate and it is the estimate of the profitability of a bond if the investor holds it till maturity and all payments are met on time in full amount.

Note that YTM has its own calculation that can be difficult to determine although, it is useful if one wants to determine the appeal of a purchased bond in comparison to other bonds with different maturity dates and coupon rates. Although the calculation has its own formula which consists of solving for the interest rate, it is not easily done on paper and is often applied using computer technology.

Investors can also calculate the overall anticipated changes in a bond’s price based on a change in interest rates, this is what we call the duration. Duration is essentially a measurement of years not to be confused with zero-coupon bonds, whose duration represents their maturity period. However, duration in our case is the change in a bond’s price given a 1% change in interest rates which is more commonly referred to as the modified duration of a bond. This duration is calculated to find a given bond’s price sensitivity in reaction to interest rate changes. In relation to the duration, bonds with longer maturities and bonds with low coupons have the highest sensitivity. Although, keep in mind duration is not a linear risk meaning that as both the price and interest rates change for a given bond, the duration changes with them.

In Summary

Bonds are debt securities that both corporations and government entities use to fund operations and projects with investors’ money. Therefore, bonds can be seen as borrowing money from the issuer’s standpoint whereas buying them is no different than an investment in a security from the investor’s point of view. This is due to the fact that investors are guaranteed a principle as well as steady income via interest payments over an agreed period. Although, some bonds include perks that classify them as a type of different type of bond. For example, callable bonds are those of which can be recalled or bought back by the issuer if they see it fit. Subsequently, when it comes to the price of bonds they are often sold at a discount when interest rates are rising and at a premium when interest rates are decreasing as the bond price is inverse to the change of accepted interest rates.