A bond (the most common type of debt security) is a type of loan. Corporations and governments borrow money regularly, often in very large amounts. For example, Apple borrowed $6.5 billion in 2021 through a long term bond issuance.
It would be difficult for Apple to borrow that entire amount from a single bank because of the risk involved. Even though Apple is one of the largest companies in the world, a default (the inability to repay borrowed funds) on a loan that large could bankrupt many banks. And even if a bank were willing to lend $6.5 billion, it would likely charge a high interest rate to compensate for the risk. The more interest a company pays, the less profit it keeps from its business operations.
Issuing bonds spreads that risk across thousands (or even millions) of investors. A $6.5 billion bond offering could be structured as 6.5 million bonds with a $1,000 par value. If 6.5 million different investors each bought one $1,000 par bond, each investor would face the risk of losing $1,000. Losing $1,000 would be painful, but it typically wouldn’t bankrupt an investor. By spreading risk this way, Apple was able to borrow a large sum and pay a relatively low interest rate (less than 1% above Treasuries).
Whether a bond investor is an individual or an institution, the investor takes the role of a bank when a bond is issued. The investor lends money, and the issuer borrows it. Issuers typically offer bonds at their face value, also called par.
Over the life of the bond:
That’s the basic structure of a typical bond, although there are exceptions. In later chapters, you’ll see specific bond types and how their features change the basic pattern.
Par value for bonds is typically $1,000, although you may see higher par values in some questions. A bond’s interest rate - also called its coupon or nominal rate - is based on par. For example:
$1,000 par, 5% bond
This bond pays $50 of interest per year. Because interest is typically paid semi-annually, that $50 is split into two payments of $25 each.
A key point: regardless of who owns the bond or what price was paid for it, the bond always pays the same dollar amount of interest based on its par value and coupon rate. The par value and coupon rate do not change over the life of the bond.
Unlike dividends, interest payments generally can’t be skipped. If an issuer fails to make an interest payment, bondholders can sue, and the issuer may be forced into bankruptcy court. In other words, missing an interest payment is a default, similar to a person being unable to pay outstanding loans.
The term “coupon” may sound odd, but it comes from history. Before the 1980s, bonds were often sold as paper certificates.
As you can see in the picture above, bond certificates were divided into two sections:
When an interest payment was due, the bondholder would clip the appropriate coupon and mail it to the issuer. Each coupon showed a date indicating when it should be clipped and mailed. After receiving the coupon, the issuer mailed the bondholder a check for the interest owed. That’s where the term “coupon” comes from.
When bonds were issued this way, they were issued in bearer form. That means “whoever bears (holds) this bond is the owner.” Cash works the same way: if you have a $20 bill, it’s yours - but if you drop it and someone else picks it up, it becomes theirs. Bearer bonds worked similarly.
In 1982, Congress outlawed the issuance of bearer bonds because they were difficult to track and easy to use for illegal purposes. Some older movies (for example, Heat) feature criminals stealing bearer bonds because they were hard for authorities to trace and could represent large dollar amounts per certificate. Bearer bonds still exist outside the United States, but they are no longer issued within the U.S.
Today, stealing bonds is much harder because of how they’re issued. Modern bonds are issued in book entry form, meaning there is no paper certificate and ownership is tracked digitally. When an investor buys a bond, ownership is recorded by the transfer agent - an organization hired by the issuer to maintain its list of bondholders. When interest and/or principal is due, the transfer agent sends payment to the investor’s brokerage firm, which then deposits the funds into the investor’s account.
A bond’s maturity is the length of time until the issuer repays the principal (par value). In general, the longer the maturity, the more risk the investor takes on. Because of that, a one-month bond typically offers a much lower return than a 30-year bond.
With a short-term bond, there’s less time for major changes to occur. Even if something unexpected happens to the issuer or the market, the bond matures soon.
With a 30-year bond, there’s much more uncertainty. Over decades, interest rates can change dramatically, recessions can occur, and markets can shift in fundamental ways. To compensate investors for these risks, longer-maturity bonds are generally issued with higher interest rates.
Depending on maturity, certain terms apply. For example, debt securities with one year or less until maturity are referred to as money markets. You’ll learn more about different types of bonds when we discuss specific U.S. government, municipal, and corporate bonds.
When a bond is created and sold to investors, the issuer sets the schedule for interest payments. These schedules are often described using shorthand. Here are two common examples:
J&J 1
F&A 15
Each pair of dates is six months apart. When an interest payment is made, it compensates the bondholder for the previous six months of ownership. For example, when a J&J 1 bond pays interest on July 1st, it’s paying interest for the period from January 1st through June 30th.
We first discussed yield in the preferred stock chapter. The idea is the same for bonds: yield measures the overall return of an investment.
For bonds, yield is influenced by several factors, including:
Interest rate (coupon)
Purchase price
Length of time until maturity
The interest rate (coupon) and yield sound similar, but they are not the same:
If a bond is purchased at a discount or premium, its yield will differ from its coupon rate.
To see why, work through these examples.
An investor purchases the following bond:
- $1,000 par
- 2 years to maturity
- 7% coupon (nominal) rate
- Purchased for $950
This bond pays $70 per year in interest (7% of $1,000). Over two years, the investor receives $140 in total interest ($70 × 2).
Because the bond was purchased for $950 and matures at $1,000, the investor also earns the $50 discount over the life of the bond. That discount adds to the investor’s overall return. The bond’s yield to maturity (overall return if held to maturity) is 10%*.
*It is very unlikely you will encounter yield to maturity on the Series 6 exam. The important concept - a discount bond’s yield will be higher than its coupon (nominal) rate because of the discount earned over the life of the bond.
Now, consider a premium bond:
An investor purchases the following bond:
- $1,000 par
- 2 years to maturity
- 7% coupon (nominal) rate
- Purchased for $1,050
This bond still pays $70 per year in interest. Over two years, the investor receives $140 in total interest.
However, because the bond was purchased for $1,050 and matures at $1,000, the investor loses the $50 premium over the life of the bond. That loss reduces the investor’s overall return. The bond’s yield to maturity is 4.3%*.
*Again, it is very unlikely you will encounter yield to maturity on the Series 6 exam. The important concept - a premium bond’s yield will be lower than its coupon (nominal) rate because of the premium lost over the life of the bond.
Here’s a good summarization of the yields of discount and premium bonds:
Discount bonds
Premium bonds
Zero coupon bonds are bonds with a 0% interest rate. They’re unusual because most bonds pay periodic interest.
While “normal” bonds pay interest semi-annually throughout the life of the bond, zero coupon bonds effectively pay their return at maturity. Investors earn money based on the price they pay compared with the amount received at maturity.
Issuers sell zero coupon bonds at discounts, and they mature at par. The longer the maturity, the deeper the discount tends to be.
For example, assume you purchase a $1,000 par, 20-year zero coupon bond issued at $600. You won’t receive ongoing interest payments, but you’ll earn $400 over 20 years ($1,000 at maturity minus the $600 purchase price). Because of this structure, zero coupon bonds are generally not suitable for investors seeking consistent income. In this example, you wouldn’t receive any cash return for 20 years.
Even though zero coupon bonds don’t pay periodic interest, their market values still respond to interest rate changes. Like other bonds, their market prices rise when interest rates fall, and vice versa. In fact, long-term zero coupon bonds can experience some of the most volatile price changes when interest rates move.
Longer-term zero coupon bonds are often used for “set it and forget it” goals, such as saving for a child’s college or for retirement. You invest today, and the bond pays a larger amount at maturity years later.
A bond is initially sold in the primary market, where the issuer receives the borrowed capital it must repay over time. After that initial sale, bonds trade in the secondary market between investors. Bondholders are not required to hold their bonds for any specific period; bonds can be bought and sold at any time, even on the same day. Like preferred stock, bond market prices are heavily influenced by interest rates.
Bond prices fluctuate for many reasons, but the most common driver is changing interest rates. Interest rates affect:
Bond prices adjust to interest rate changes in a predictable way: when interest rates go up, bond values go down (and vice versa).
To see why, walk through this example. Assume you purchase a 20-year, $1,000 par, 4% bond at par from the issuer during the bond’s initial public offering (IPO). At the time you bought the bond, the average market interest rate was 4%. You’ll receive $40 per year in interest, paid as two semi-annual payments of $20. That interest amount stays fixed for the life of the bond.
Now suppose that a few years later, market interest rates rise to 6%. That’s bad for your bond’s market value. If you try to sell your bond for $1,000, you’ll likely struggle to find a buyer. Your bond is competing with new 6% bonds being issued at par, and most investors would prefer a 6% bond paying $60 per year over a 4% bond paying $40 per year.
If you lower the price, the bond becomes more attractive. For example, if you drop the price to $800, a buyer would receive:
That additional $200 increases the buyer’s overall return. The lower the bond’s price, the higher the yield (overall return) for the investor buying it.
When a bond trades at any price lower than par ($1,000), it trades at a discount. Discount bonds provide two sources of return:
In the example above, a buyer would receive $40 per year in interest plus the $200 discount over the life of the bond.
Now consider the opposite situation. Using the same bond, assume market interest rates fall to 2%. Your 4% bond is now attractive because it pays more interest than newly issued bonds. If you try to sell it for $1,000, it would likely sell quickly.
Because demand is higher, you may be able to sell it for more than $1,000. Suppose you raise the price to $1,200. A buyer would still receive the 4% coupon payments, but they would lose money at maturity because the bond still pays only $1,000 at maturity.
When a bond trades at any price higher than par ($1,000), it trades at a premium. Premium bonds create a tradeoff for investors:
In the example above, a buyer would receive $40 per year in interest but would lose $200 over the life of the bond.
How can an investor compare bonds and decide which offers the best return? A bond’s yield is designed to answer that question, and we’ll return to it in a future section.
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