A bond is a type of debt security. In plain terms, it’s a loan.
People take out loans to buy cars, start businesses, or purchase homes. When you take out a loan, you repay:
Some loans are short-term, while others last for decades.
Bonds work the same way. The issuer (the borrower) promises to repay:
If you purchase a bond, you’re lending money to the issuer. In that sense, investors are acting like the bank.
Here’s what that looks like in practice:
Issuers often borrow huge amounts - hundreds of millions of dollars or more. You’ve probably heard that the US federal government is over $31 trillion in debt. To finance its activities, the US Treasury continually borrows to sustain its deficit spending (spending more money than it collects in taxes). Too much debt* can lead to a bad financial situation and is something to keep an eye on if you’re an investor.
*Although US government debt is significant and climbing, economists have varying opinions on the severity and impact of US debt levels. For test purposes, you should assume US government debt securities are safe, regardless of the fact our government is trillions in debt.
You learned about par value in the preferred stock chapter. While there are some differences, the basic idea is similar for bonds.
Par value is a bond’s face value. It represents the loan’s principal, and it doesn’t change. Many bonds are initially issued in the primary market at their par value. A bond’s interest payments are also based on par, just like preferred stock dividend payments are based on par.
We’ll talk in depth about how bond values fluctuate later in this unit. For now, assume bond market values fluctuate similarly to preferred stock.
The key point is this: the issuer’s interest obligation is based on par, not on the bond’s current market price.
Assume the following:
A $1,000 par, 5% bond trades at $900
Although this bond is trading at $900, it still pays 5% of $1,000 for the life of the bond. The issuer must make $50 annual payments (technically two $25 semi-annual payments) over the bond’s life. The market price does not affect the issuer’s obligation to make the fixed $50 annual payments.
The fixed par value for bonds is typically $1,000. In addition to being the basis for interest payments, par value is also what’s received when a bond matures (discussed later in this chapter).
Bonds are fixed income investments, meaning they make consistent fixed payments to investors.
When an issuer sells a bond, it sets the bond’s interest rate based on the current market environment. Depending on:
…the bond’s interest rate may be higher or lower than the current average interest rate.
This is similar to everyday borrowing. If you’re approved for a loan, the interest rate reflects factors like the type of loan (e.g., personal, real estate, business), the length of the loan, and the borrower’s credit score.
If a bond exposes investors (creditors) to higher risk, the issuer usually has to offer more to attract buyers - typically a higher interest rate. For example, a company facing financial difficulties may issue a bond with an interest rate of 12% when the average rate is 5%. The extra interest compensates investors for the risk they’re taking.
If a bond is relatively safe and low-risk, the issuer can often sell it with a lower-than-average interest rate. For example, the US Government is considered the safest bond issuer. A US Government bond could be issued with a 3% interest rate when the average interest rate is 5%. Investors don’t demand high interest rates because US Government bonds are relatively low-risk.
Issuers try to set rates that are:
Once the interest rate is set, it never changes over the bond’s life.
Once a bond is sold to investors in an initial public offering (IPO) in the primary market, the issuer collects the money raised and uses the new capital in various ways. Some issuers use bond proceeds to build new factories, purchase new technology, or hire additional employees. Regardless of the reason, the issuer is now legally obligated to pay the borrowed funds back to bondholders.
Unlike dividends, issuers may not skip interest payments. If this occurs, bondholders will sue and take them to bankruptcy court.
The coupon, the stated rate, or sometimes just the rate are nicknames for the interest rate. The term “coupon” is a historical reference. Before the 1980s, bonds were often issued 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:
When an interest payment was due, the bondholder would clip the appropriate coupon and mail it to the issuer. Each coupon showed 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. That’s where the term “coupon” comes from.
Bonds issued this way were considered to be in bearer form, meaning “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 $20. But if you drop the $20 on the sidewalk and someone else picks it up, it’s now their $20.
Bearer bonds were treated the same. In 1982, Congress outlawed the issuance of bearer bonds because they were hard to track and easy to use for illegal purposes. There are many older movies (like Heat) where bank robbers attempt to steal bearer bonds. They still exist outside of the United States but are no longer issued within our country.
Today, bonds are much harder to steal because of how they’re issued. Most bonds are now issued in book-entry form, meaning there is no paper certificate and ownership is tracked digitally. When you buy a bond, your ownership is recorded by the transfer agent. There’s no need to clip coupons or safeguard certificates.
Most bonds make regular, semi-annual payments to investors. When the bond is created and sold, the issuer sets the payment dates. These dates are often described using a shorthand.
Let’s look at two common interest payment schedules:
J&J 1
F&A 15
Each pair of dates is six months apart. When an interest payment is due, the issuer pays bondholders for the previous 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 are bonds with a 0% interest rate.
Most bonds pay interest semi-annually throughout the bond’s life. Zero coupon bonds work differently: they pay interest at maturity. Investors earn a return based on the price they paid for the bond.
Issuers sell zero coupon bonds at discounts, and the bonds mature at par. This form of return is sometimes referred to as capital accumulation.
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 unsuitable for investors seeking consistent income. In this example, you wouldn’t see any return from your bond for 20 years.
Longer-term zero coupon bonds can appeal to investors who want a “set it and forget it” investment. In general, the longer the maturity, the deeper the initial discount (and the bigger return). The idea is straightforward: issuers usually need to offer greater incentives when they want to borrow investor funds for long periods.
Many investors buy longer-maturity zero coupon bonds for long-term goals, such as saving for a young child’s college or retirement. You invest today, and the bond makes a larger payment later at maturity.
All debt securities have a specific maturity date. The maturity date determines how long the bond will last.
Some debt securities are issued with maturities as short as a few days, while others have 40 year maturities. The time until maturity depends on how long the issuer needs to repay the borrowed funds.
In general, the longer the maturity, the more risk involved. Because of this, a one month bond typically has a much lower rate of return than a 40 year bond. Only so much can happen in a short period.
Like any other loan, the most significant risk a bondholder faces is not being repaid (known as default risk). Even if something drastic changes with the issuer or the bond market, a short-term bond matures soon.
A 40-year bond involves much more uncertainty. Over the next 40 years, we could experience significant interest rate changes, 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 a debt security’s maturity, specific terms may apply. For example, those with one year or less until maturity are called money markets. You’ll learn more about different types of bonds when we discuss specific versions of US Government, municipal, and corporate bonds.
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