fbpx

What is a Bond?

Benzinga Money is a reader-supported publication. We may earn a commission when you click on links in this article. Learn more.

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 are Bonds?

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

Here are the bond terms you’ll come across most often:

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.

How to Invest in Bonds: an 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. This can help you calculate a rough estimate of how your bond investment might mature over time.

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.

Type 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.

Options with Investing in Bonds

  1. Individual bonds (government/corporate/municipal, etc.)
  2. 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.
  3. 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 of Investing in Bonds

  • 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 of Investing in Bonds

  • 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.

Compare Bond Brokers

Best For
Intermediate Traders and Investors
Overall Rating
Get started securely through Webull’s website
Best For
Intermediate Traders and Investors
N/A
1 Minute Review

Webull, founded in 2017, is a mobile app-based brokerage that features commission-free stock and exchange-traded fund (ETF) trading. It’s regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Webull offers active traders technical indicators, economic calendars, ratings from research agencies, margin trading and short-selling. Webull’s trading platform is designed for intermediate and experienced traders, although beginning traders can also benefit.

Webull is widely considered one of the best Robinhood alternatives.

Best For
  • Active traders
  • Intermediate traders
  • Advanced traders
Pros
  • Commission-free trading in over 5,000 different stocks and ETFs
  • No account maintenance fees or software platform fees
  • No charges to open and maintain an account
  • Leverage of 4:1 on margin trades made the same day and leverage of 2:1 on trades held overnight
  • Intuitive trading platform with technical and fundamental analysis tools
Cons
  • Does not support trading in mutual funds, bonds or OTC stocks
Best For
Futures Trading
Overall Rating
Get started securely through TradeStation’s website
Best For
Futures Trading
N/A
1 Minute Review

TradeStation is for advanced traders who need a comprehensive platform. The brokerage offers an impressive range of investable assets as frequent and professional traders appreciate its wide range of analysis tools. TradeStation’s app is also equally effective, offering full platform capabilities.

Best For
  • Advanced traders
  • Options and futures traders
  • Active stock traders
Pros
  • Comprehensive trading platform and professional-grade tools
  • Wide range of tradable securities
  • Fully-operational mobile app
Cons
  • Confusing pricing structure to leave new traders with a weak understanding of what they pay
  • Cluttered layout to make navigating TradeStation’s platform more difficult than it should be
Best For
Options Trading
Overall Rating
Get started securely through TD Ameritrade’s website
Best For
Options Trading
N/A
1 Minute Review

This publicly listed discount broker, which is in existence for over four decades, is service-intensive, offering intuitive and powerful investment tools. Especially, with equity investing, a flat fee is charged, with the firm claiming that it charges no trade minimum, no data fees, and no platform fees. Though it is pricier than many other discount brokers, what tilts the scales in its favor is its well-rounded service offerings and the quality and value it offers its clients.

Best For
  • Novice investors
  • Retirement savers
  • Day traders
Pros
  • World-class trading platforms
  • Detailed research reports and Education Center
  • Assets ranging from stocks and ETFs to derivatives like futures and options
Cons
  • Thinkorswim can be overwhelming to inexperienced traders
  • Derivatives trading more costly than some competitors
  • Expensive margin rates
Best For
Advanced traders
Overall Rating
Get started securely through Moomoo’s website
Best For
Advanced traders
N/A
1 Minute Review

Moomoo is a commission-free mobile trading app available on Apple, Google and Windows devices. A subsidiary of Futu Holdings Ltd., it’s backed by venture capital affiliates of Matrix, Sequoia, and Tencent (NASDAQ: FUTU). Securities offered by Futu Inc., regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Moomoo is another great alternative for Robinhood. This is an outstanding trading platform if you want to dive deep into smart trading. It offers impressive trading tools and opportunities for both new and advanced traders, including advanced charting, pre and post-market trading, international trading, research and analysis tools, and most popular of all, free Level 2 quotes.

Get started right away by downloading Moomoo to your phone, tablet or another mobile device.

Best For
  • Cost-conscious traders
  • Novice traders
  • Active/Advanced traders
Pros
  • Free Level 2 market data for all users who open an account
  • Commission-free trading in over 5,000 different stocks and ETFs
  • Over 8,000 different stocks that can be sold short
  • $0 contract fee for trading options, no commission either
  • Strong market data and analysis tools with over 50 technical indicators
  • Access trading and quotes in pre-market (4 a.m. to 9:30 a.m. ET) and post-market hours (4 p.m. to 8 p.m. ET)
  • No minimum deposit to open an account.
  • Active trading community with more than 100,000 app users
Cons
  • No phone or chat support

Final Thoughts on Bond Investing

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.

Ready to invest in bonds? Read Benzinga’s guides on how to buy bonds, the best bond funds and the best bond ETFs.

Turn to Webull

0 Commissions and no deposit minimums. Everyone gets smart tools for smart investing. Webull supports full extended hours trading, which includes full pre-market (4:00 AM - 9:30 AM ET) and after hours (4:00 PM - 8:00 PM ET) sessions. Webull Financial LLC is registered with and regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). It is also a member of the SIPC, which protects (up to $500,000, which includes a $250,000 limit for cash) against the loss of cash and securities held by a customer at a financially-troubled SIPC-member brokerage firm.