How Do Bonds Work?

June 30, 2021 Cassandra Wood

How Do Bonds Work?

A bond is an IOU. Governments and businesses can raise money for their projects by requesting money from investors. The organizations who raise money through bonds are called bond issuers. The groups or individuals who provide the money are called bond buyers, or bond holders.

The bond buyer lends money to the bond issuer who agrees to pay them back on a specific date. As an incentive or reward, bond buyers also receive interest for agreeing to lend their money. They receive these “interest” payments every year until the agreed upon date.

Here are some important vocabulary words related to bonds.

Face Value

The face value, also known as the principal, is the value of the bond itself. The amount of money that the bond buyer paid for the bond could be different. They will receive this amount if they still own the bond when it “matures”. The face value is usually $1000, but there are exceptions.

Coupon

This is the amount of interest you receive on your bond every year. It is called the coupon rate and is calculated as a percentage (%). You multiply your coupon rate by your face value to get your coupon. Coupons can be paid as one or multiple payments per year, usually twice a year.

For example, if a bond has a coupon rate of 4% you will receive $40 every year. You may receive two payments of $20 instead of one coupon of $40. Note: these calculations are based on a face value of $1000.

Maturity Date

The maturity date is when the bond expires. This is when the bond issuer pays back all the bond holders. If you are holding the bond on the maturity date, then the bond issuer will pay you the face value of the bond.

You will also receive one final payment of whatever interest that you may be qualified for. After this point the bond issuer’s debt to the bond holder is settled. There is no more IOU.

Government Bonds

Government bonds are called treasury bonds. These bonds are issued by governments who need to raise money for public projects or operations. Any level of government can issue bonds. When you hear about the National Debt of a country, it usually means the amount of bonds it has issued.

Government bonds can be traded by normal investors, countries, or different parts of the government. In the United States, the Federal Reserve buys and sells bonds from the US Treasury to influence interest rates.

Corporate Bonds

When companies issue bonds they are called corporate bonds. Smaller companies will take out a loan out from a bank, like how an individual or family would. If the company is big, like Apple (AAPL) they need more cash than banks have available to give away. The company will issue bonds to investors instead. That way they can access a larger pool of people who have money to invest.

Bonds are one of two ways that companies use to raise money. The other way is by issuing stocks. Here are the differences between the two:

If you buy a bond, you lend money to a company, and they promise to pay you back later with interest.
If you buy a stock, you buy a part of that company and you now own part of it.
The value of the bond comes from how much you lent the company and the interest rate they will pay you back.
The value of a stock comes from how much the company is worth (including all its assets and businesses).
Bonds expire.
Stocks do not expire.

How can you buy or sell bonds?

Bonds can be bought and sold just like stocks. You can also buy and hold them to maturity when you will receive the face value. The price you pay for the bond may be more or less than the face value. While you own a bond, you receive a certain amount of interest (or coupons) that will be paid each year. This interest was set before the bond was issued and does not change.

Investors buy bonds because they are less risky than other investments. This means they would rather have the guaranteed coupon payments, (interest) than risk losing their money on riskier investments. However, not all bond issuers are trustworthy. Some of them could default on their payments, which means you don’t get paid back for the money you lent them.

Test Your Knowledge

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Rating

A rating is given to bonds to determine their level of riskiness. When a bond issuer is low risk, that means they pay back their bonds in full and on time. A high-risk issuer is more likely to “default,” which means they will not have the money to pay you back.

Rating systems differ from company to company, but it is important to know the difference between different bond ratings. The most common bond ratings are as follows:

AAA: strongest quality rating, this has a very low risk of default.
AA+ to AA-: high-quality investment grade.
A+ to BBB-: Medium-quality investment grade.
BB+ to BB-: Low-quality non-investment grade. Also called “junk bonds” and there is a high risk of default.
CCC+ to C: Speculative bonds with a very high risk of default.
D: Bonds in default for not paying principal and/or interest.

If you see a bond has a AAA rating, the bond issuer is trustworthy. They always meet their obligations. You can trust you will get your money back. The opposite is true of D ratings, this means the bond issuer has not paid the face value or the coupon payments for their bonds in the past.