A bond is a specific 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 pay back borrowed funds) on a loan that large could bankrupt many banks. And even if Apple found a bank willing to lend $6.5 billion, the bank would likely demand 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 many investors. The $6.5 billion Apple bond offering is equivalent to 6.5 million $1,000 par bonds. If 6.5 million different investors each bought one $1,000 par bond, each investor would face the risk of losing their investment. Losing $1,000 would be painful, but it typically wouldn’t bankrupt an investor. By spreading risk around, Apple was able to borrow a large sum and pay a relatively low interest rate (yielding less than 1% above very safe U.S. government Treasury securities).
When a bond is issued, investors - whether individuals or institutions - take the role a bank would normally play: they lend money to the issuer. 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 the following chapters, we’ll look at specific types of bonds and how they work.
The 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 stated as a percentage of par. For example:
$1,000 par, 5% bond
This bond pays $50 of interest per year. Because interest is typically paid semi-annually, that annual amount is split into two payments of $25.
A key point: regardless of who owns the bond or what price they paid for it, the bond always pays interest based on its par value and stated coupon rate. The par value and coupon rate don’t change over the life of the bond.
Unlike dividends, interest payments 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. Missing a required payment is a default, similar to a person being unable to pay outstanding loans.
The term “coupon” may sound strange, but it comes from how bonds used to be issued. Before the 1980s, bonds were commonly sold as paper certificates.
Bruce C. Cooper Collection/Wikimedia Commons/"San Francisco Pacific Railroad Bond WPRR 1865"/Public domain
As you can see in the picture above, bond certificates were divided into two sections. Most of the certificate represented the principal, or par value, of the bond. The coupons were at the bottom (in grey). When an interest payment was due, the bondholder would clip the appropriate coupon and mail it to the issuer. Each coupon listed a date showing when it should be clipped and mailed. After receiving the coupon, the issuer sent 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. If you drop it and someone else picks it up, it becomes theirs. Bearer bonds worked the same way.
In 1982, Congress outlawed the issuance of bearer bonds because they were hard to track and easy to use for illegal purposes. Some older movies (e.g. Heat) feature criminals stealing bearer bonds because authorities couldn’t easily trace them and each certificate could represent a large amount of money. Bearer bonds still exist outside the United States, but they are no longer issued within the U.S.
Today, bonds are much harder to steal because of how they’re recorded. Bonds are now 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 deposits the funds into the investor’s account.
A bond’s maturity is the length of time until the issuer repays the 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 rate of return than a 30-year bond. Over a short period, fewer things can change, and investors can often make reasonable predictions about the near-term bond market. Even if something unexpected happens, the bond matures soon.
A 30-year bond leaves much more time for uncertainty. Over decades, interest rates can fluctuate significantly, the economy can go through downturns, and markets can change in fundamental ways. To compensate investors for these risks, longer-maturity bonds are generally issued with higher interest rates.
Depending on maturity, 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.
When a bond is created and sold, the issuer sets the schedule for interest payments. The schedule is often written in a shorthand that combines months and a day of the month. 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 pays for the period from January 1st through June 30th.
Zero coupon bonds are bonds with a 0% interest rate. They’re unusual because most bonds have coupons above 0%.
While typical bonds pay interest semi-annually throughout the bond’s life, zero coupon bonds pay their return at maturity. Investors earn money based on the price they pay for the bond compared with the amount they receive 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, suppose you buy a $1,000 par, 20-year zero coupon bond issued at $600. You won’t receive ongoing interest payments, but you’ll receive $1,000 at maturity. Your total return is $400 over 20 years.
Because they don’t provide regular payments, zero coupon bonds generally aren’t suitable for investors who want consistent income. In this example, you wouldn’t receive any cash return for 20 years.
Even though zero coupon bonds don’t have a coupon rate, their market values still respond to changes in market interest rates. Like other bonds, their market prices rise when interest rates fall, and vice versa. Later in this chapter, we’ll see why long-term zero coupon bonds can be especially volatile when interest rates change.
Longer-term zero coupon bonds are often used for long-term goals, such as saving for a young child’s college or for retirement. The idea is simple: invest today, and receive a larger payment at maturity years later.
A bond is first sold in the primary market, where the issuer receives the borrowed capital (money) it must repay over time. After that initial sale, the bond can trade in the secondary market between investors.
Bondholders aren’t required to hold their bonds for any specific period. Investors can buy and sell bonds at any time, even on the same day. The market price of bonds is largely driven by interest rates, similar to preferred stock.
Bond prices fluctuate for many reasons, but the most common driver is changing interest rates. Interest rates affect:
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).
Let’s walk through an example. Suppose you buy 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 buy it, the average market interest rate is 4%. You’ll receive $40 per year, paid as two semi-annual payments of $20. That interest amount won’t change over the life of the bond.
A few years later, 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. Most investors would prefer a 6% bond paying $60 per year over your 4% bond paying $40 per year.
If you lower the price, the bond becomes more attractive. For example, if you offer it at $800, a buyer would receive:
That $200 difference increases the buyer’s overall return. The lower the price, the higher the yield (overall return) for the investor buying the bond.
When a bond trades below par ($1,000), it trades at a discount. Discount bonds provide two sources of return:
In the example above, the 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, suppose market interest rates fall to 2%. Your 4% bond is now attractive because it pays more interest than new bonds being issued around 2%.
If you try to sell your 4% bond for $1,000, it would likely sell quickly. Strong demand for a higher-coupon bond can push the market price above par. If you raise the price to $1,200, a buyer still gets the higher coupon, but they give up some return because they paid more than par.
When a bond trades above par ($1,000), it trades at a premium. Premium bonds create a tradeoff:
In this example, the buyer would receive $40 per year in interest but would lose $200 over the life of the bond (paying $1,200 and receiving $1,000 at maturity).
So how do you compare returns across bonds trading at different prices? A bond’s yield is designed to answer that question, and we’ll cover it in a future section.
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