The basics
A bond is a unique form of a loan. Organizations like corporations and governments borrow money continually and in large amounts. For example, Apple borrowed $6.5 billion in 2021 through a long-term bond issuance.
It would be difficult for Apple to find a bank to borrow this amount of money from due to the risk involved. Although Apple is one of the largest and most powerful companies in the world, a default (the inability to pay back borrowed funds) would bankrupt most banks. Even if Apple could find a bank willing to lend $6.5 billion, a high interest rate is virtually guaranteed due to the significant risk a loan of that size presents. The more interest a company pays, the less profit it keeps from its business operations.
Issuing bonds spreads the risk among thousands, if not millions of investors. The $6.5 billion Apple bond offering equates to 6.5 million $1,000 par bonds. If 6.5 million different investors bought a $1,000 par bond, each investor faces the risk of losing their investment. Losing $1,000 wouldn’t be fun, but it also wouldn’t bankrupt most investors. By spreading risk around, Apple was able to borrow a significant sum of money and pay a relatively low interest rate (yielding less than 1% above very safe U.S. government Treasury securities).
General characteristics
Whether a bond investor is a person like you or an institution, investors take the role of a bank when a bond is issued. Issuers tend to initially offer bonds at their face value, also known as par. Over the life of the bond, the issuer (borrower) pays the investor (lender; creditor) interest, typically in semi-annual (twice-a-year) payments. At the end of the bond, also known as its maturity, the issuer makes one last interest payment and repays the face (par) value. This is how the average bond works, but there are always exceptions. In the following chapters, we’ll learn about specific types of bonds and how they function.
The par value for bonds is typically $1,000, although it’s possible you could encounter questions with higher par values. The bond’s interest rate, also known as its coupon or nominal rate, is based on par. For example:
$1,000 par, 5% bond
This bond will pay two $25 interest payments a year, totaling $50 of annual interest. Regardless of who owns the bond or what price was paid for the bond, it always pays this amount of interest. The par value and the interest rate never change over the life of the bond.
Unlike dividends, interest payments cannot be skipped. If the issuer skips an interest payment, they will be sued by the bondholders and taken to bankruptcy court. Simply put, bond issuers must make their interest payments. Otherwise, it’s considered a default, similar to a person declaring bankruptcy because they can’t pay outstanding loans.
The term ‘coupon’ might sound out of place, but there’s a historical reference. Before the 1980s, bonds were generally sold in certificate form.
As you can see in the picture above, bond certificates were divided into two different sections. The majority of the certificate represents the principal or par value of the bond. The coupons are at the bottom of the certificate (in grey). When an interest payment was due, the bondholder would clip the appropriate coupon and mail it to the issuer. Each coupon displayed a specific date that told the investor when it should be clipped and mailed. After receiving the clipped coupon, the issuer sent the bondholder a check for the interest owed. This is where the term ‘coupon’ comes from.
When bonds were issued this way, they were issued in bearer form. This is another way of saying “whoever bears (holds) this bond is the owner.” Cash works the same way. If you have a $20 bill in your pocket, it’s your money. However, if you drop the $20 on the sidewalk and someone else picks it up, it’s now theirs. Bearer bonds are treated exactly the same.
In 1982, Congress outlawed the issuance of bearer bonds because they were difficult to track and easy to utilize for illegal purposes. There are some older movies (e.g. Heat) involving bank robbers stealing bearer bonds (because they were difficult for authorities to track and represented large amounts of money per certificate). Bearer bonds still exist outside of the United States, but are no longer issued within our country.
Nowadays, it’s very difficult to steal bonds because of their form. Bonds are now issued in book entry form, which means there is no certificate and everything is tracked digitally. When an investor buys a bond, their ownership is tracked by the transfer agent, which is an organization hired by the issuer to maintain its list of bondholders. Because of the digital capabilities of the modern world, there’s no need to clip coupons or worry about safeguarding certificates. When interest and/or principal is due, the transfer agent simply sends payment to the investor’s brokerage firm, which then deposits the funds into the investor’s account.
Maturity
The longer the maturity of the bond, the more risk is involved. Because of this, a one-month bond typically has a much lower rate of return than a 30-year bond. Only so much can happen in a short period of time and investors can usually predict what will happen in the bond market over the next several weeks. Even if something drastic changes with the issuer or the bond market, the bond will mature shortly.
A 30-year bond has a lot of time on its hands. Do you know where you’ll be or what the world will look like in 30 years? Probably not. The more time involved, the more uncertainty and risk. Over the next 30 years, we could experience significant interest rate fluctuations, economic downturns, and fundamental changes in the market. To compensate investors for these potential risks, bonds with longer maturities are generally sold by issuers with higher interest rates.
Depending on the maturity of a bond, certain terms may 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 versions of US Government, municipal, and corporate bonds.
Interest payments
When a bond is created and sold to investors, the issuer sets specific intervals for the interest payments. These intervals are stated in a type of “finance language.” Let’s take a look at some common bond interest payment intervals:
J&J 1
- Pays interest on January 1st and July 1st
F&A 15
- Pays interest on February 15th and August 15th
Each of the dates above is six months apart. When an interest payment is due, the issuer pays bondholders for their last six months of bond ownership. For example, when a J&J 1 bond pays interest on July 1st, it pays the bondholder for owning the bond from January 1st - June 30th.
Zero coupon bonds
Zero coupon bonds are exactly what they sound like - bonds with a 0% interest rate. These are a unique type of bond; most bonds have interest rates above 0%.
While “normal” bonds pay interest semi-annually throughout the life of the bond, zero coupon bonds pay interest at maturity. Investors make money from a zero coupon bond based on the price they originally purchase the bond for. Issuers sell zero coupon bonds at discounts, and they mature at par. The longer the maturity of the bond, the deeper the discount.
For example, assume you purchase a $1,000 par, 20-year zero coupon bond issued at $600. You won’t receive ongoing interest from the issuer, but you obtain a return of $400 over 20 years. Unlike most bonds, zero coupon bonds are not suitable for investors seeking consistent income. In our example, you wouldn’t see any return from your bond for 20 years!
Although zero coupon bonds do not have an interest rate, their market values are influenced by interest rate changes in the market. Just like other bonds, their market prices rise when interest rates fall, and vice versa. In fact, we’ll learn later in this chapter how long-term, zero coupon bonds experience some of the most volatile changes in price when interest rates change.
Longer-term zero coupon bonds are great for investors seeking a “set it and forget it” type of investment. Many investors purchase zero coupon bonds with longer maturities for long-term goals, such as saving for a young child’s college or retirement. Invest today, forget about it, and several years later the investment will make a big payment to you. Easy, right?
Market prices
A bond is initially sold in the primary market, which provides the issuer the borrowed capital (money) it must pay back over time. After this initial sale, the bonds trade in the secondary market between investors. Bondholders are under no obligation to hold their bonds for any set period of time; investors can even buy and sell their bonds on the same day. The market price of bonds is largely dependent on interest rates, just like preferred stock.
Bond prices fluctuate in the market based on various factors. The most common factor is changing interest rates. Not only do interest rates influence the coupon of the bond when it’s issued, they also continually influence bond market prices. Bond market values adjust to interest rate changes just like preferred stock market values. When interest rates go up, bond values go down (and vice versa).
To reiterate this point, let’s work through an 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 annually from the bond through two semi-annual payments of $20. The amount of interest you receive will not fluctuate or change over the life of the bond.
As a few years pass by, interest rates will change. Let’s say they rise to 6%, which would not be good for your bond’s value. If you tried to go back to the market and sell your bond for your original purchase price of $1,000, you probably wouldn’t find a buyer. Why? Your bond is competing with new 6% bonds being issued at par. There aren’t many reasons why an investor would prefer your 4% bond that pays $40 annually over a 6% bond paying $60 annually.
You might not be able to sell your bond for $1,000, but what if you dropped the price? If you dropped your bond to $800, it would be much more marketable. Remember, bonds mature at par, so the investor purchasing your bond would make the 4% coupon, plus the difference between their purchase price ($800) and the par value ($1,000). That’s an additional $200 the investor earns over the life of the bond! The lower the price of your bond, the higher the yield (overall return) for the investor purchasing your bond.
When a bond trades at any price lower than par ($1,000), it trades at a discount. Discount bonds give their investors two different forms of return. First, the coupon provides ongoing semi-annual interest. Second, the investor receives the difference between the purchase price and the maturity value (par). If another investor purchased your bond in the previous example, they would receive $40 annually in interest, plus the $200 discount over the life of the bond.
We also need to think through the alternate situation. Assume the same example, except interest rates fall to 2%. If you want to sell your 4% bond in the market, it won’t be very difficult. Your bond is paying an interest rate that’s higher than the current rate of interest in the market. When bond investors are searching for bonds to invest in, most new issues are being offered around 2%. Your bond is attractive!
If you attempted to sell your 4% bond for $1,000, it would be sold immediately. The demand for your higher interest rate bond will allow you to raise the market price and still sell the bond. What if you raised the price to $1,200? If another investor purchased your bond, they would receive a higher rate of interest than the current market, but they would lose some return based on the bond’s purchase price.
When a bond trades at any price higher than par ($1,000), it trades at a premium. Premium bonds give their investors conflicting returns and losses. Just like any other bond (other than zero coupon bonds), premium bonds pay ongoing semi-annual interest. However, the investor loses money on the difference between their purchase price and the maturity value (par). If an investor purchased your bond in the previous example, they would receive $40 annually in interest, but would lose $200 over the life of the bond.
How can an investor determine which bond provides the highest rate of return if they’re looking at several different bonds? In a future section, we’ll discuss how a bond’s yield answers this question.
Secured vs. unsecured bonds
When a loan is obtained, it will either be secured or full faith and credit. This applies to everything from bonds to mortgages to car loans to student loans. If a bond is secured, it is backed by something of value. If a bond is full faith and credit, it is only backed by the borrower’s promise to pay back the loan.
A bond is collateralized if it is secured, meaning there is collateral backing the loan. Mortgages are secured loans; if you fail to make your mortgage payments, the bank will take your home. Similarly, if a bond has collateral backing their bond, it is secured in the same way. If the issuer fails to pay bondholders their interest and/or principal, the collateral will be liquidated (sold) and the funds will be passed on to the bondholders. Examples of collateral pledged by bond issuers include real estate, equipment, and subsidiaries.
If a bond is full faith and credit, also known as unsecured, it is only backed by the issuer’s promise to pay back the borrowed funds. If the issuer fails to make the required payments, they can still be sued by the bondholders. However, there is no collateral backing the bond. If the issuer has little-to-no capital (money) left, bondholders could lose their entire investment.
Secured bonds are safer investments, and therefore are typically issued with lower interest rates and trade at lower yields. To compensate their investors for risk, unsecured bonds are issued with higher interest rates and traded at higher yields.
Callable bonds
We first learned about call features in the preferred stock chapter. It’s exactly the same with bonds. If a bond is callable, it allows the issuer to pay back its principal (par) value prior to maturity and put an end to the bond earlier than maturity. When a bond is called, the issuer must pay accrued interest (interest earned up to the sale), its par value, and any call premium (discussed below) to bondholders. After the bond is called, the issuer no longer pays interest and the bond ceases to exist.
An issuer calling a bond is similar to a person paying off a loan early. They repay the principal of the loan to the lender and no longer make interest payments. The borrower is happy to stop paying interest, but the lender could be losing out on years of interest income. Callable bonds work the same way!
There are a few good reasons an issuer would call a bond. The most common is to refinance. Assume an issuer has a $100 million 7% bond outstanding, which results in the issuer paying $7 million in interest payments annually. If interest rates fall to 3%, they could issue a new bond with a 3% coupon and use the money raised to call the older, 7% bond. By doing so, they’ve reduced their interest rate by 4%, which results in saving $4 million in interest annually (going from paying $7 million in interest on the 7% loan to paying $3 million in interest on the 3% loan). If you’ve ever refinanced a loan, you know this process.
An issuer could also call a bond simply because they have money to do so. It’s similar to paying off a credit card loan because there’s money in the bank. Why would anyone pay interest on borrowed funds when they don’t need to?
Callable bonds are issuer-friendly and not beneficial to bondholders. More often than not, bonds are called when interest rates fall. If you owned the 7% bond referenced above and were called, it would be very difficult to find another 7% yielding bond in a 3% interest rate environment. In order to do so, you would need to seek out a much riskier bond. This is an example of call risk.
Because of the risk they expose investors to, callable bonds are issued with higher interest rates than similar non-callable bonds. While the feature is a benefit to issuers, it costs them because of the larger interest payment requirements. In the market, callable bonds trade at lower prices, which offer higher overall rates of return to their investors.
We already learned about call protection and call risk in the preferred stock chapter. As a reminder, call protection is the number of years before a security can be called. A call premium is any amount of money above par ($1,000) that an issuer must pay to call a bond.
Here’s a video breakdown of a question involving both call protection and call premiums:
Even if a bond isn’t callable, an issuer could still attempt to put an end to their debts earlier than maturity. They could simply go to the market and attempt to purchase as many bonds back as possible. Additionally, a debt issuer could also entertain issuing a tender offer to current bondholders. A tender offer is a formal offer to investors to buy back their securities typically at a premium to its market value.
Put features
A put feature is similar to a call feature, except for who controls it. If a bond is puttable, it allows the bondholder to sell the bond back to the issuer for its par value prior to maturity. Puttable bonds are attractive to investors, especially if interest rates rise.
When interest rates rise, bond values fall because of their fixed coupon. If new bonds being issued today have higher interest rates than older bonds trading in the secondary market, those older bonds must be sold at a discount to make them marketable. However, puttable bonds should never trade at discounts. If you owned a bond that was puttable, why would you ever sell it in the market for less than $1,000? You could just put the bond back to the issuer and force them to pay back its par value ($1,000).
Investors tend to put their bonds when interest rates rise so they can lock in higher rates of return. If you held a puttable 4% bond and interest rates were to rise to 8%, you should put your bond. The issuer would pay you back your $1,000 par value, which could then be used to buy a newly issued bond with similar features providing an 8% rate of return.
Price volatility
When interest rates change, bond market values fluctuate in the market. Bonds with longer maturities and lower coupons tend to see the most price volatility.
When a bond has a long maturity, it tends to be more sensitive to interest rate changes. Time has a compounding effect on market values. Assume you own a 1-year bond and a 20-year bond in your portfolio. When interest rates rise, market values for both bonds will fall. The 20-year bond’s price will fall more in price. Let’s talk about why.
When interest rates rise, it makes current bonds less valuable. Existing bond values are dependent on the interest rates of new bonds. When interest rates rise, new bonds become more valuable (they’re being issued with higher rates than before), leading to existing bonds falling in value.
While both the 1-year and the 20-year bond will fall in value, the 1-year bond won’t fall as much. Within one year, the investor will receive their par value back. At that point in time, the investor can reinvest their money back into a new bond with a higher rate of interest.
The other bond has a 20-year wait until that can happen. It’s locked in at the lower rate of interest until it matures or is sold. This is why bonds with longer maturities fall further in price when interest rates rise.
When interest rates fall, long-term bonds rise further in price for the same reasons. Going back to our comparison, the 1-year bond will rise in price, but not by much. It matures within one year; if the investor decides to reinvest their money back in the market, they will buy a bond with a lower rate of return.
The other bond has a higher interest rate that’s locked in for the next 20 years. Because of this, the market value of the 20-year bond will rise much further than the 1-year bond.
Bonds with lower coupons have more price volatility than bonds with higher coupons. To understand this, assume you own two 10-year bonds. One has a 2% coupon and the other has a 10% coupon.
When interest rates rise, the value of both bonds will fall. The 2% coupon bond will fall further in price because it has less interest to reinvest back into the market at the new, higher rate of interest. The 10% coupon bond pays much more interest and gives more money to the bondholder to reinvest back into the market at the new, higher rate of interest.
The lower the coupon of a bond, the more likely it was sold at a discount. If a bond’s value is mostly from its discount, the investor must wait until maturity to make money from the bond’s discount. The 10% bond is more valuable in this situation because the 10% bond pays more interest that can be reinvested at higher rates right now.
When interest rates fall, the value of both bonds will rise. The 2% coupon bond will rise further in price because its value is likely tied to a discount. Remember, the lower the coupon, the more likely the bond was sold at a discount. When much of the bond’s value is achieved at maturity when the investor receives the par value of the bond, it is not required to reinvest large sums of money at lower rates of return.
The 10% bond pays much more interest to its bondholder. If the bondholder decides to reinvest their interest back into the market, they are forced to now buy bonds with lower rates of return as interest rates fall. The 10% bond is less valuable in this situation because the 10% bond pays more interest that would be reinvested at lower rates right now.
Here’s a video breakdown of a practice question regarding price volatility:
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