A bond is similar to an IOU («I owe you» ) that is issued by a company, government or other financial institution in exchange for cash. Like stocks, it can be traded in financial markets.
An understanding of bonds
When a company needs money, there are two choices: to sell stocks in themselves or to borrow money. In this case, a bond-issuing organization is borrowing money from investors. Bond investors are lenders because the bond issuer owes them repayment of their funds. They can sell their bond to other investors, allowing the bond to trade in the market. When the bond is due (when it “matures”), the bond issuer repays the bond’s owner and usually makes interest payments (“coupons”) along the way. However, because businesses can fail, there is no guarantee that bondholders will be paid back.
The main point:
a bond = an IOU you can trade, but without the guarantees
A bond establishes a borrower-lender relationship. The borrower is the company that issues the bond, and the lender is the investor who purchases the bond. Borrowers receive cash, while lenders typically receive interest payments. However, companies, entities, and governments that issue bonds may go out of business, which may result in the bond investor not receiving the IOU repaid.
There are four main groups:
1. Corporations: they issue bonds to raise cash for launching the projects, leasing new properties, acquiring another company, or other aims.
2. Municipal governments: Municipal bonds are issued by local governments or states in the United States. They are commonly referred to as “munis” for short. Depending on where they live, some investors may find that purchasing a muni bond in their home state has tax advantages over other bonds because home-state interest payments may be tax exempt.
3. Federal governments: Bonds issued by the federal government are among the least risky investments available because they are guaranteed by the US government’s “full faith and credit,” and they are known as “Treasury bonds” or “Treasuries.” The United States government issues Treasuries and uses the proceeds to fund government employee salaries, military contracts, public health initiatives, and other government spending needs
4. Others: There are some other organizations, which can also issue bonds to finance themself for growth opportunities, like universities or public transit agencies.
Type of bonds
Convertible bonds are corporate bonds that allow the bondholder to exchange the bond for proportionally priced company stock. Because the bondholder benefits from the option to convert the bond, the interest rate paid by the bond issuer is typically lower than that of a standard non-convertible bond. The bond issuer benefits from lower interest rates because you benefit from convertibility.
Zero coupon bonds are not paying a coupon interest payment to the bondholder. Instead of that, they are sold at a lower (discounted) price than their final face value. So the potential benefit to the investor is the difference between the amount paid to purchase the bond and the amount repaid at maturity. The bond issuer does not pay out any interest or coupons along the way.
Bonds that can be terminated early by the issuer or the investor are called callable or puttable bonds.
A callable bond. Prior to the bond’s scheduled maturity, the issuer of a callable bond has the right to “call” (demand) the bond. Since the potential to call a bond early is advantageous to the issuer and costly to the bondholder, the issuer typically charges the bondholder a higher interest rate to make up for it.
A puttable bond. This type of bond can be “put” (sold back to the issuer) by the bondholder at certain times before the maturity date. It is beneficial for bondholders to be able to put a bond back to the bond issuer. To compensate the issuer for that cost, the bond tends to offer a lower interest rate paid to the bondholder.
Bonds in the markets
Bonds are traded on public securities exchanges just like stocks. Government bonds may be purchased directly from government institutions or through a bond broker. Even buying funds made up of bond investments would expose you to bonds. The price and the interest rate are the two essential components of a bond that must be understood in order to determine its value, regardless of how you access bonds.
Interest rates: The issuer’s interest rate is what gives a bond its value to an investor. The interest rate that an issuer must pay depends on how creditworthy it is, or how likely it is to repay the bond when it matures. For riskier bonds, investors should anticipate higher interest rates.
Prices: Investors can benefit from purchasing a bond at a discount (lower) price and having it repaid at the full price. The “full price” is known as “face value,” and for a bond, it is typically $1,000. It is possible to purchase a bond at a discount price such as $900 and be repaid the full face value of $1,000 at maturity. The $900 bond may also lose value if the issuer is at risk of defaulting or actually defaults. Defaulting means failing to make legally required payments to the bondholder.
Interest rates and bond prices have an inverse relationship that resembles a see-saw. Bond prices tend to fall when interest rates in the economy rise.
About bond risks
There are no guarantees that an investor will generate a fair return from a bond investment. Bonds are claimed as less risky than stocks because issuers are legally obligated to repay bondholders but not shareholders. Bonds can be used by investors to diversify and reduce the overall risk of their portfolios by balancing what is invested in stocks. However, bond issuers can go bankrupt, and bondholders may lose their entire investment. Bond prices are less volatile than stock prices in general, but here are two major risks.
Default Risk: A default occurs when a borrower (the bond issuer) fails to pay the bondholder’s interest payments or even the entire principal. This is typically caused by the company becoming insolvent, which occurs when it incurs more debt than it can repay. Defaults are frequently associated with bankruptcies, which are legal proceedings that determine what happens to an insolvent company.
Interest Rate Risk: The bond issuer pays interest to the bondholder in the form of coupon payments, and the bondholder wants the highest coupon payments possible given the bond’s risk. If interest rates rise and other companies (with comparable risk levels) begin issuing bonds at higher interest rates, your bonds may become less appealing to investors. As a result, the bond’s price may fall.
Always take into consideration:
Bond rating = risk level of the bond
If your university friend asks you to borrow money to buy some food, you can analyze his ability to pay you back. Credit rating agencies take a similar approach when evaluating bond issuers, but they typically conduct more rigorous and complex analysis to determine an issuer’s creditworthiness. They also publish the results of their analyses, known as credit ratings, to assist investors in making decisions.
Credit ratings are produced by different separate companies (such as Fitch or Standard & Poors) to evaluate the financial health and creditworthiness of an issuer of bonds. They use many factors, but focus on evaluating the company’s capability to repay its debts. If its business is growing in terms of sales and profits, its credit rating is more likely to improve than if it is not. When a country experiences an economic downturn, its government credit rating is more likely to suffer.
- Investment grade indicates a moderate to low risk of default. These are companies with ratings of Baa or higher (from Moody’s) or BBB or higher (from Standard & Poor’s) (for S&P). The highest grade is Aaa or AAA, which is held by only a few governments, corporations, and other bond issuers.
- Non-investment grade = high credit risk. These issuers, commonly referred to as “junk bonds,” have high debt levels — investors should be aware that their bonds have a significantly higher risk of default. In exchange, investors will typically demand higher interest rates to compensate for the additional risk they are taking on.
Are bonds = fixed income?
The answer is YES. That is the technical term referring to bonds in general. Because many bonds pay a consistent coupon payment to the bondholder, the bondholder receives a fixed amount of income from the company that issued the bond. Fixed income investments may be appealing to retirees who rely on their investments for consistent income streams to fund their lifestyles.