FinEdFriday: What are Bonds?
In this series, we are going to address some common financial questions from the ground up, using the simplest terminology, so that everyone can share an understanding of the basics. Whether you are just learning for the first time, or using these posts as a refresher, we hope we can set the record straight on some of the most commonly used terms in the finance industry.
In our last post (What Are Stocks), we discussed how companies that are looking to raise capital, in order to grow their business, can split the ownership of the company into shares and offer them to potential shareholders at a price. These shareholders get to share in the company's potential profit in the form of the shares appreciating, and possibly in the form of a dividend payout.
Companies (and governments) have another tactic as they look to fund their growth or maintenance…
They can “issue” bonds. And just when you thought the stock market was large and complicated, the bond market is around 80% larger and immensely more complicated! None the less, let’s take a quick look.
A bond is a fancy IOU that a company or government body issues as debt. “If you give us X dollars now so that we can pay for Y, we will pay you back in Z months/years.” Some bonds issued will include a fixed or variable interest payment called a “coupon” payment.
Here are a few terms:
Issue Price – What you originally lend the issuer by buying a bond. Some bonds are priced at a premium and some at a discount, but most are priced at “par,” which is usually $1,000. Investors buy any of the three for different reasons. At a discount, an investor might buy a bond for $975. At a premium, an investor might buy a bond for $1,020.
Face Value – this is the value of the bond when it “matures,” or what investors expect to be paid at the end of the IOU. As an example, the face value of a bond is $1,000. This means that regardless of the original purchase price, the investor will receive $1,000 at the end of their holding period.
Coupon and Coupon Rate – The coupon is the interest payment an investor receives for buying the bond, usually expressed by a percentage. A 3% coupon on a $1,000 bond is $30 per year. That 3% is the coupon rate.
Maturity Date and TTM – This is the amount of time that must pass before the issuer pays an investor the face value. The IOU is complete.
What sets bonds apart from one another?
Time to Maturity – the amount of time it takes for a bond to mature can range from a few months to several years. As you can imagine, the structure of a bond looks different if an issuer is holding money for 6 months than it does if they are holding money for 6 years.
Credit Rating – This is corporate and government debt we are talking about, so a bonds riskiness is determined by how trustworthy they are. Three of the largest and most well-known credit rating agencies are Moody’s, Standard & Poor’s, and Fitch. Bonds with high credit ratings are considered “investment grade” bonds and are very stable (think bonds issued by the U.S. Government or a long-standing company). Bonds with low credit ratings are considered “junk” bonds, are less stable, and can offer higher coupon rates to make their bonds more attractive.
Categories – Corporations, municipalities/states, governments, and agencies all issue different types of bonds. For example, municipal bonds can offer a coupon payment that is tax-free.
Special Features – Some bonds give investors the right to “convert” their bond into stock at a certain point in time. Other bonds do not have a coupon payment (zero-coupon bonds), so they offer their bonds at a discount to make them more attractive. Some bonds even make it so that the issuer can “call” a bond back before its maturity date, or allow the investor to “put” the bond back to the issuer before the maturity date.
How do you make money from bonds?
The main way investors make money on bonds is by their coupon payment. This payment is fixed on a schedule determined at issuance, which is why you may hear people refer to bonds as “fixed-income” vehicles (investments).
Also, if you buy a bond at a discount, and are paid par at maturity, you profit in the difference. This may not seem like a big pay day, but there can be some sort of guarantee behind that amount, and if you hold several bonds, the profit can add up.
Bonds can serve as a diversifier to an overall portfolio. They are not directly correlated to stocks, and can be less volatile (sometimes), so many people use them to “buoy” their overall portfolio in different market and interest rate climates.
Alright. I believe that is enough for now. If you made it this far, know that this is just scratching the surface of bond investments. Hopefully, you are more aware of the terminology when people mention things like:
“I invest in stocks and bonds.”
or
“Captain America helped sell war bonds before he became an Avenger.”
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.