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What Is a Bond?

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.

Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.

KEY TAKEAWAYS:

  • Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
  • A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.
  • Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.
  • Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.
  • The Issuers of Bonds:

    Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams or other infrastructure. The sudden expense of war may also demand the need to raise funds.

    Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide.

    Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.

    bonds advantages and disadvantages

    How Bonds Work:

    Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents.
    Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.

    When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

    The initial price of most bonds is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.

    Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

    Categories of Bonds

    There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms.

    • Corporate Bonds

    Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.

    • Municipal Bonds

    Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.

    • Government Bonds

    Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1–10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "treasuries." Government bonds issued by national governments may be referred to as sovereign debt.

    • Agency Bonds

    Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

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    Characteristics of Bonds

    Most bonds share some common basic characteristics including:

    Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium $1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.

    The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.

    Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments

    The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.

    The issue price is the price at which the bond issuer originally sells the bonds.