What are Bonds?

Bonds are essentially a formal I.O.U (I owe you) used to borrow money. You buy the bond in return to getting interest over a given period of time. When a corporation or government needs money, they issue bonds that people buy. In turn, the issuer (the person who sells the bond) takes the money. However, no one would buy something if they didn’t get something in return, so the issuer will offer to not only pay the person back at a specified date but also provide some interest along the way.

There are two major types of bonds:

Government Bonds

These bonds are issued by governments who want to raise cash. It can be raised by any level of government; large cities often issue bonds to fund public projects, while national governments issue bonds to fund the government. When you hear about the National Debt of a country, it usually means the amount of bonds it has currently issued.

Government bonds can be traded by normal investors, but they can also be bought and sold between countries. If you hear a news pundit mention that the US government owes money to another country, like China, it’s usually because that country purchased a very large number of government bonds.,

Bonds can also be traded between different parts of the government too. In the United States, the Federal Reserve buys and sells bonds from the US Treasury in order to influence the prevailing interest rates, for example.

Corporate Bonds

Corporations can also sell bonds, which is like borrowing money from a large pool of investors. Smaller companies will usually take out a loan from the bank, but large corporations like Apple (AAPL) use more cash than banks can usually give out in one single loan. Instead, they will issue bonds to investors, with a promise to pay them back at a certain date with interest.

Bonds are one of two ways that companies use to raise money for their operations. The other way is by issuing stocks. There are very important differences between the two:

• If you buy a bond, you’re lending money to a company and they are promising to pay you back later with interest.
• If you buy a stock, you are buying a piece of that company and are entitled to part of its profits (in the form of dividends).
• The value of the bond comes from how much you lent the company, and the interest rate they will pay you back at.
• The value of a stock comes from how much the company itself is worth (including all its assets and businesses).
• Bonds expire; at the expiration date you receive back the amount you lent.
• Stocks do not expire.

Details:

Bonds can be bought and sold just like stocks, or they can be bought once and held to maturity at which point they will expire and return the face value. When you buy a bond and hold it to maturity, you receive a certain predetermined interest rate (or coupon).

Remember that while a bond represents an amount of money that you lent to a government or company, they can still be bought or sold between investors like stocks. This means that you can buy a bond from Google (GOOG), and later sell it to another investor who will then continue to collect the interest and receive the amount you initially lent Google when you bought the bond. Similarly, you can buy bonds from other investors rather than buying them directly from the company that issued them.

Investors will typically buy bonds when they are risk averse, meaning they would rather have the guaranteed payment of regular interest than make riskier investments like stocks, whose value can rise and fall a lot over time.

Test Your Knowledge

See if you can match the attributes below to either stocks or bonds. Drag each of the attributes into the correct box, and click the check button to see if you got them all!

Here a few terms that are important when looking at bonds:

Face Value

The face value, also known as par value, or the principal, is the amount of money you will receive when the bond matures. This is almost always $1,000 but there can be exceptions.

Coupon

This is the amount of interest you receive on your bond every year. It’s usually stated in terms of the coupon rate (in percent). Multiply your coupon rate by your face value to get your coupon. For example, if a bond is quoted at 4.00% you will receive $40 every year, (assuming your face value is $1,000). Bonds can also be paid multiple times per year, and are usually semi-annual (twice per year). In this case, your coupon rate stays the same at 4.00% but you would receive two coupons of $20 instead of one coupon of $40.

Maturity

The maturity date is when the bond expires. If you’re holding the bond on the maturity date then the bond issuer will pay you the face value of the bond, which is almost always different from what you initially paid for it.

In addition to the face value of the bond, if your bond had a coupon, then you will also receive one final payment of whatever interest has accrued since the last payment was made. After this point, the bond issuer’s debt to the bond holder is considered to be settled.

Yield

When you buy a bond, the payment you get back when it matures is fixed. That means the amount doesn’t increase or decrease, no matter what happens. However, the price of the bond can go up and down in the market, depending on different factors. Bond yield is usually given as a percentage. The bond yield is affected by the prevailing market rate, the risk free rate, or the interest rate set by the US Federal Reserve.

When the price of the bond increases, the yield (the amount you get back when it matures divided by the amount you paid for the bond) decreases. When the price of the bond decreases, the yield increases. The higher the yield, the better the bond looks compared against other investments.

Accrued Interest

The interest payments on bonds are not paid daily; they are usually paid out once or twice a year (depending on the bond). However, the bond issuer owes whoever holds the bond interest for as long as they held it. So, if you only owned a bond for a day, you’re still entitled to one day’s worth of interest.

This is important for investors who buy and sell bonds a lot. If you own a bond that pays interest once per year on July 1st, but you sell it to someone else on June 15, you’re still entitled to most of the interest payment that they will receive from the bond issuer on July 1.

For example, lets say John bought a 5% 10-year semi-annual bond on the day it was issued, and waits one year and 2 months before selling it to Kelly. This means John received two $25 coupons in the first year, and is entitled to another $8.33 from the bond issuer on top of the price he sold the bond for. This is because he held it for another two months hence 2/6 * $25 = $8.33.

Accrued Interest with Pricing

Accrued interest has a huge impact on a bond’s price. Investors look at this in terms of a bond’s dirty price and clean price. The dirty price is the price the bond trades for on the markets (for example, you bought a bond from another investor). This price does not subtract the accrued interest from the bond’s value. The clean price is the price with that accrued interest factored out.

Dirty Price = Clean Price + Accrued Interest

When you get a quote for a bond, you are almost always quoted the clean price, but when you buy it you will always pay the dirty price.

Rating

A rating is given to bonds to determine their level of riskiness. They are generally performed by third party auditing firms such as Standard and Poors, Moody’s or Fitch. Ratings system 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. The strongest quality rating, this has a very, very low risk of default.
AA+ to AA-. A very high quality investment grade.
A+ to BBB-. A medium quality investment grade.
BB+ to BB-. A low quality (non-investment grade) junk bond, with a high risk of default.
CCC+ to C. A speculative bond with a very high risk of default.
D. Bonds in default for not paying principal and/or interest.

Portfolio

Nearly every balanced portfolio should have a place for bonds, if only for their strong safety while still beating inflation. Bonds can also be very risky, such as junk bonds, where the issuer is very likely not to pay you back. They may pay high coupon rates, but have a high risk of default. There are also many different types of bonds as well, such as convertible bonds, that can be turned into stocks, or inflation protected bonds that simply follow the rate of inflation.

Bond ETFs

You can also get exposure to bonds through bond ETF’s such as BND or LQD. They have some notable differences between bonds with regards to tax considerations and returns, but are much easier to trade.

Notes on Trading Bonds

Pop Quiz