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What is a Bond?

Though bonds as an investment class don’t generate the highest returns, they have their own appeal. They offer portfolio diversification, generate steady returns even in the face of a highly volatile investment environment, provide tax advantages and more. Therefore, if you don’t know what bonds are and want to learn how to start investing in bonds, it’s important to know at least the basics of bond investing, and gaining insight on bonds is the first step toward a robust bond-investing education.

What is a bond?

Bonds are fixed-income securities which provide investors with fixed periodic payments and the eventual return of principal at the end of the tenure of the security.

In other terms, bond is an agreement signed between a bond issuer and investor, which specifies the fixed amount the bond issuer is obligated to pay the investor at specified intervals. A bond is a loan advanced by the bond purchaser to the bond issuer, and is a debt instrument that functions like an IOU.

Bond terms to know

Face value: The face value (also known as “par value”) of a bond is the price of the bond when it is first issued; the principal amount or the value at which it is redeemed at maturity. Usually, bonds are issued at face value in multiples of $1,000.

Interest rate: Also known as coupon rate or nominal interest rate, it is the interest rate stated on the bond. It is the fixed  annual interest paid by the bond issuer to the bond holder. Coupon interest payment is determined as a percentage of the bond’s face value, and is a dollar amount. Therefore, it is fixed over time.

Maturity: The end of a bond’s term is called its maturity.

Premium: If the price of a bond is above its par value, the difference between the bond price and the par value is called the premium. In this case, the bond yield will be less than its stated coupon rate.

Discount: Alternatively, if a bond is trading below its par value, the deficit of the bond price over the par value is called the discount.

Bond price: The price of a bond is equal to the present value of future interest payments, plus the present value of the face value (returnable at maturity) based on the prevailing market interest rate.

Yield: Yield of a bond at a particular time is the bond interest rate expressed as a percentage of the then prevailing price of a bond. It is the rate of return one gets by investing in a bond. In accounting terms, yield is the present value of the cash flows from the bond, which is equal to the principal plus all remaining coupons.

Yield to maturity: It is the rate of return an investor in bond will earn on purchasing it at the current market price and holding it until maturity.

Call provision: It is a clause or a provision on a bond, which allows the bond issuer to repurchase the bond before the maturity period.

Put provision: A clause that states that the bond can be sold back to the issuer at a stipulated price before the maturity of the bond, with the price usually set at 100 percent of the face value. Usually multiple put periods are specified for a put bond. This offers an extra degree of protection to bond buyers, given that it establishes a floor price for the bond.

Bond example

Let us assume company XYZ issues a 10-year dollar bond with face value of $10,000 for a fixed coupon rate of 5 percent. An investor is eligible to receive $500 each year or $250 every six months.

In the above example, the bond parameters are as follows:

  • Par value of the bond – $10,000
  • Coupon rate – 5%
  • Coupon interest – $500/year or $250 every six months
  • Duration of the bond – 10 years

When the purchase price of a bond is equal to the par value, then its coupon rate is equal to the yield-to-maturity.

Assuming that an investor buys the same bond we discussed earlier, in the secondary market for $9,000. Its current yield will equal 5.56% (coupon amount/bond price *100). Since the coupon amount does not change, it remains at $500.

If the bond is sold at a premium in the secondary market at $11,000, the current yield equals 4.55%.

Thus, we see that bond price and bond yield share an inverse relationship, which is quite logical since the mathematical yield equals coupon/bond price *100.  With the coupon remaining the same, any increase in bond price will lead to a decline in yield and vice-versa.

Factors affecting bond price

When bonds are traded in the secondary market, the price of the bond is influenced by the demand and supply of the bond. The other factors that affect the price are:

Interest rates: Bond price and interest rate share an inverse relationship. Interest rate in this case means the benchmark interest rate. Taking the same example we considered earlier and the rate on short-term treasury security as the benchmark interest rate is how the relation can be explained.

If the treasury rate is the same 5%, both the treasury and company XYZ’s bond will offer the same return of $500 per year. Let us assume, due to deteriorating fundamentals, the interest rate on the treasury falls to 3%, so it fetches you $300 compared to the $500 XYZ’s bond yields. The higher yield of XYZ’s bond makes it an attractive option, sending its price higher. The price of the bond rises until its return becomes equal to the reduced returns from the treasury.

Conversely, when the treasury rate rises to 7%, it would fetch you $700. Given the lower returns from company XYZ’s bond, demand for it dwindles, sending its price lower. The price of the corporate bond drops till its yield becomes equal to the enhanced yield of the treasury.

Inflation: Bond prices also share an inverse relationship with inflation. In an inflationary environment, the future returns you earn from a bond will be worth less in today’s dollar. This is because inflation erodes the purchasing power of the returns you will earn on your investment.

Credit rating of the bond: The credit rating assigned to a bond by a rating agency indicates the ability of a bond issuer to pay the periodic interest payments and repay the principal amount at the time of maturity. A higher credit rating will lead to a higher bond price.

Bond yield: As explained earlier, bond prices and bond yield share an inverse relation.

Types of bonds

The Financial Industry Regulatory Authority (FINRA) lists the following types of bonds in its website:

U.S. Treasury securities: These are issued by the federal government, and with the U.S. government backing them with its “full faith and credit,” these are considered the safest bond investment option. Treasury securities can be a treasury bill (maturity period of four weeks, 13 weeks, 26 weeks or 52 weeks), treasury notes (maturity period of two, three, five, seven and ten years) and treasury bonds (maturity period of 30 years).

U.S. savings bonds: These are also issued by the government and backed by the “full faith and credit” guarantee, the difference being they can be purchased for as low an investment as $25 and they cannot be bought or sold in a secondary market.

Mortgage-backed securities, or MBS: These bonds are secured by home and real estate loans. Banks offering mortgage loans pool loans with similar characteristics from among these and sell them to a federal government agency or a government-sponsored enterprise such as Fannie Mae, Freddie Mac or a financial institution. These agencies/institutions in turn issue MBS, with the pooled loans serving as collateral for the MBS.

Corporate bonds: These bonds are issued by corporations to raise finances for various end uses such as general corporate purposes, mergers and acquisitions, capital expenditures, etc.

Municipal bonds: These are issued by states, cities, counties and other government entities to raise money for building infrastructure or financing other public projects.

International bonds: These are issued by foreign governments or companies.

As is always the case, with higher risks comes higher returns. Bonds, safer bets relative to equities, have mostly underperformed equities. One area where bonds score over equities is consistency of returns.

Over a 10-year period ending Sept. 30, 2014, U.S. equities generated an average annual return of 8.11%. This compares to the 4.62% average annual return generated by bonds in the same period.

However, there are turbulent periods such as post-Dotcom Bubble burst, when bonds out performed equities.

Bond investing options

Individual bonds (government/corporate/municipal, etc.)

Bond funds: These are mutual funds invested primarily in bonds and other debt instruments. Units in the bond funds can be sold any time for the current net asset value.

Bond ETFs: These are hybrid instruments because they track a bond index in an attempt to replicate its return but they trade on a stock exchange, giving it a stock-like property. Examples are bond ETFs are iShare Core U.S. Aggregate Bond ETF, Vanguard Total Bond Market ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF.

Pros to bond investing

  • Bonds are a safe-haven investment option. In the eventuality of the company going bankrupt, bondholders have preference over shareholders in recovering the investment made.
  • Bonds yield steady returns, unlike stocks, which can go from generating staggering returns to wiping away all of your investment dollars. Bonds, especially the ones guaranteed by the government, fetch steady returns, and preserve  your principal investment.

Cons to bond investing

  • Bonds generate less returns than other, riskier options such as equities.
  • Investing in bonds exposes an investor to interest rate risk. As seen earlier, when interest rate falls, investors will flock to the bonds yielding higher interest rate, sending their prices higher.
  • Inflation also serves as a risk to bond investor, as higher inflation has the potential to wipe away the returns from a bond.
  • Credit risk is also associated with certain bonds not guaranteed by “full faith and credit” of the government are at the mercy of the bond issuer’s creditworthiness.

Final thoughts

To reap the advantages as well as mitigate the shortcomings of bond investing, it’s important to  consider a portfolio approach rather than considering bond investing as a solo investment option. Zero in on the right stock-bond-cash mix based on your investment objective and time horizon, and you should be good to go. 

In these current economic times, as interest rates go up due to the Fed’s monetary policy normalization, bond investing looks a bit risky. Bonds issued in the future may come with better rates, making your investment in today’s bond less appealing. That said, there’s no denying that bonds’ presence stabilize  portfolios, which makes it them an appealing investment option at any time.