What are Bonds?
Bonds are loans made to large organizations. These include Treasuries, agency bonds, corporate bonds, municipal bonds and more. An individual bond is one minuscule piece of a massive loan. Like really MASSIVE. So massive that it requires them to borrow money from more than one source.
To better understand bonds and bond funds, let’s start with the basics.
What is a Bond?
A bond is a loan that an investor makes to a corporation, government, federal agency or other organization. Bonds are sometimes referred to as debt securities. Since no one in their right mind would lend money without compensation, that’s where bonds come into play.
The issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest. The bond issuer also agrees to repay you the original sum loaned at the bond’s maturity date. There are cases, such as a bond being called, that causes the repayment to be made earlier.
The vast majority of bonds have a set maturity date. This is a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities or investments, because they pay you interest based on a regular, predetermined interest rate. This is also called a coupon rate that is set when the bond is issued. You will often hear the term “bond market” which is used interchangeably with “fixed-income market.”
Confused yet? Don’t worry, it gets easier!
You heard me mention bond maturity but what is it exactly?
A bond’s term, or years to maturity, is set when it is issued. Bond maturities can range from one day to 100 years, but the majority range from one to 30 years.
Bonds are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. The safest are short-term U.S. Treasury bills, but they also pay the least interest.
Medium- or intermediate-term bonds are generally those that mature in four to 10 years. Medium-term Treasuries, like the benchmark 10-year note, offer less risk and higher yields.
Long-term bonds are those with maturities greater than 10 years. 30-year Long-term Treasury bonds often pay a full percentage point or two more interest than five-year Treasury notes. Why? They carry a greater risk that higher inflation could reduce the value of payments. Also, that higher overall interest rates could cause the bond’s price to fall.
The borrower fulfills its debt obligation when the bond reaches its maturity date. The final interest payment and the original sum you loaned (the principal) are paid to you.
Holler Back Bonds
As I mentioned earlier, not all bonds reach maturity. These are called callable bonds and they are common. They allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond’s prospectus and the indenture. Make sure to read these because both documents explain the bond’s terms and conditions.
Most firms are not required to document all call provision terms on the confirmation statement but many do. When you buy municipal securities, firms are required to provide more call information on the confirmation. This is more than you normally see on other types of debt securities.
You can receive call protection for a period of the bond’s life (i.e. the first three years after the bond is issued). This means that the bond cannot be called before a specified date. After that, the bond’s issuer can redeem that bond on the predetermined call date, or a bond may be continuously callable. What does that mean? This means the issuer may redeem the bond at the specified price at any time during the call period. Before you buy a bond, always check to see if the bond has a call provision!
What is a bond coupon?A bond’s coupon is the annual interest rate paid on the issuer’s borrowed money. This is generally paid out semiannually. The coupon is always tied to a bond’s face or par value, and is quoted as a percentage of par. For instance, a bond with a par value of $1,000 and an annual interest rate of 4.5 percent has a coupon rate of 4.5 percent ($45).
Many bond investors rely on a bond’s coupon as a source of income or reinvest it. If the interest rate at which you reinvest your coupons is higher or lower, your total return will be more or less. Be aware of the tax man because taxes can reduce your total return.
Hopefully you have already my article about the power of compounding. Regardless of the type of investment you select, saving regularly and reinvesting your interest income can turn even modest amounts of money into sizable investments. And bonds are no different through the power of compounding.
If you save $200 a month and receive a 5% annual rate of return, you will have more than $82,000 in 20 years’ time. Pretty amazing right? Use compound interest to your advantage. That’s why investing sooner, even in small amounts, is better than not investing at all.
Not sure how to invest? Read my Investing for Beginners Guide.
Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market. You will likely catch the bond between coupon payment dates. If you’re selling, you’re entitled to the price of the bond, plus the accrued interest that it earned up to the sale date. The buyer compensates you for this portion of the coupon interest. This is generally handled by adding the amount to the contract price of the bond.
Let’s look at an example. Assume a bond has a fixed coupon that is to be paid semiannually on June 1 and December 1 every year. If a bondholder sells this bond on October 1, the buyer receives the full coupon payment on the next coupon date scheduled for December 1. In this case, the buyer must pay the seller the interest accrued from June 1 to October 1. As mention, the price of a bond includes the accrued interest usually. This price is called the full or dirty price.
Bonds are generally issued in multiples of $1,000, which we learned is the bond’s face or par value. But note, a bond’s price is subject to market forces and will fluctuate above or below par. If you sell a bond before it matures, you may not receive the full principal amount of the bond and any remaining interest payments. This is because a bond’s price is not based on the par value of the bond. Instead, the bond’s price is established in the secondary market and fluctuates. As a result, the price may be more or less than the amount of principal. The remaining interest the issuer is required to pay you if you held the bond to maturity.
The price of a bond can be above or below its par value for many reasons, including:
- interest rate adjustments
- bond credit rating have changed
- supply and demand
- a change in the creditworthiness of a bond’s issuer
- whether the bond has been called or is likely to be (or not to be) called
- a change in the market interest rates
If a bond trades above par, it was traded at “premium.” If a bond trades below par, it was traded at a “discount.”
Let’s look at an example. If a bond has a fixed interest rate of 8 percent, and similar-quality new bonds available for sale have a fixed interest rate of 5 percent. You will likely pay more than the par amount of the bond that you intend to purchase, because you will receive more interest income than the current interest rate (5 percent) being attached to similar bonds.
What’s next? The Bond Series: Types of Bonds