What is a Bond? – A Comprehensive Guide • Benzinga

Bonds are fixed-income investment products that pay you a steady, predictable income over time. While they won’t make you rich overnight, they offer portfolio diversification and predictable income when markets get volatile. 

Knowing what a bond is and how they work is an important step toward building a smart, diversified portfolio. 

What Are Bonds?

A bond is a fixed-income security that provides investors with set periodic interest payments and the eventual return of principal at the end of its maturity. It’s essentially a loan advanced by the bond purchaser to the bond issuer and is a debt instrument that functions like an IOU.

Governments and companies issue bonds to raise capital for projects or to grow a business. Investors can hold on to them and collect the interest, or they may trade them on an open market.  

Types of Bonds

U.S. Treasury Securities

Treasury Securities are considered the safest bonds because they’re issued and backed by the U.S. government which guarantees that the interest and principal will be paid on time. There are three main types: Treasury bills (maturity period of one year or less), Treasury notes (maturity period of two to 10 years) and Treasury bonds (maturity period of 20 or 30 years). 

U.S. Savings Bonds

Savings bonds are also issued by the U.S. government and can be purchased for as low as $25, but they can’t trade in a secondary market. They’re a low-risk investment that allows individuals to lend money to the government and earn modest interest over time. 

Agency Bonds

An agency bond is issued by a government-sponsored enterprise like Fannie Mae and Ginnie Mae. While it is not fully backed by the government, it is considered high quality. 

Corporate Bonds

They are issued by corporations to raise finances for various purposes such as general business, mergers and acquisitions and capital expenditures.

Mortgage-Backed Securities

These bonds are secured by home and real estate loans. Banks offering mortgages may pool loans with similar characteristics and sell them to financial institutions or to a federal government agency or government-sponsored enterprise such as Fannie Mae and Freddie Mac. These institutions, in turn, issue mortgage-backed securities, with the pooled loans serving as collateral.

Municipal Bonds

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

Convertible Bonds

A convertible bond is a combination of debt and equity. It can be converted into a predetermined number of shares of the issuing company’s stock, at a future date, typically at a predetermined conversion price. This allows the bondholder to potentially benefit from any increase in the company’s stock price. Convertible bonds provide flexibility for both the issuer and the investor, as they offer the potential for capital appreciation while also providing a fixed income stream through regular interest payments.

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’s first issued. It’s the principal amount or the value at which it is redeemed at maturity. Bonds are usually issued at face value in multiples of $1,000.
• Interest Rate: Also known as coupon rate or nominal interest rate, it’s the fixed annual interest paid by the bond issuer to the bond holder. It’s determined as a percentage of the bond’s face value.
• Maturity Date: The end of a bond’s term is called the maturity date and determines the profitability of your investment. For example, a long-term bank bond that matures several years from now pays out over that entire period. A short-term bond might pay well, but it’s far less consistent because it matures quickly.
• Premium: If the price of a bond is above its par value, the difference is the premium. In this case, the bond yield will be less than its stated coupon rate.
• Discount: If a bond trades 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: The yield of a bond at a particular time is the bond interest rate expressed as a percentage of the prevailing price at that time. It’s the rate of return one gets by investing in a bond.
• Yield to Maturity: It’s the rate of return an investor in a bond will earn on purchasing it at the current market price and holding it until maturity.
• Treasury Direct: TreasuryDirect is the only place where investors may purchase and redeem U.S. Savings Bonds electronically.

How to Invest in Bonds: An Example

Let’s assume company XYZ issues a 10-year bond with a face value of $10,000 for a fixed coupon rate of 5%. 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, its coupon rate is equal to the yield to maturity. However, let’s assume an investor buys the same bond on the secondary market for $9,000. Its yield would change to 5.56% (coupon amount ÷ bond price x 100.) If the bond is sold at a premium on the secondary market at $11,000, the yield would be 4.55%.

Thus, we see that a bond’s price and its yield share an inverse relationship. With the coupon remaining the same, any increase in bond price leads to a decline in yield and vice-versa. 

Factors Affecting Bond Prices

Bond prices in the secondary market are influenced by demand and supply, but other factors also affect them. 

Interest Rates

Bond prices and interest rates have an inverse relationship. The interest rate here is the benchmark interest rate. When interest rates increase, existing bond prices usually drop. This happens because new bonds offer higher yields, making older bonds less attractive. If investors need to sell their bonds before maturity, they may incur capital losses. Economic indicators, central bank policies, and inflation rates affect interest rates. 

Taking the same example we considered earlier, we can explain the relation better. 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’s 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 have an inverse relationship with inflation. In an inflationary environment, the future returns from a bond will be worth less in today’s dollar since inflation erodes the purchasing power of the returns you earn on the investment.

Credit Ratings

The credit rating assigned to a bond by a rating agency indicates the ability of a bond issuer to make the periodic interest payments and repay the principal amount at maturity. A higher credit rating will lead to a higher bond price. Bonds rated AAA are highly rated and lower risk. These are often issued by stable entities, such as governments or large corporations. While they have lower yields, they appeal to risk-averse investors due to their reliability. On the other hand, bonds rated B or lower may offer higher yields, but they also come with a higher risk of default. These bonds can provide better returns, but they may lead to significant losses if the issuer struggles financially. 

Current Events

Bond prices shift as current events alter investor sentiment and interest rates. Bonds issued by foreign banks may be affected by news impacting that country or region. For example, bonds issued by a French bank or the French government are highly-susceptible to incidents that impact France, the European Union or its territories.

Your Options When Investing in Bonds

• Individual bonds: These include bonds from sources such as government organizations, corporations and municipalities.
• Bond funds: A bond fund is a mutual fund invested primarily in bonds and other debt instruments. Units in the bond funds can be sold at any time for the current net asset value (NAV). This liquidity makes bond funds attractive for those who want exposure to bonds without managing individual bond holdings.
• Bond exchange-traded funds (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 of bond ETFs are iShares Core U.S. Aggregate Bond ETF and Vanguard Total Bond Market ETF.

Pros of Investing in Bonds

• Bonds are often seen as a safer investment option. In the eventuality of a company going bankrupt, bondholders have preference over shareholders in recovering the investments they made.
• Bonds yield steady returns and preserve the principal amount, unlike stocks, which can go from generating staggering returns to wiping away all of your investment dollars.

Cons of Investing in Bonds

• Bonds typically generate lower returns than other, riskier securities.
• Bond investors are exposed to interest rate risk. When rates fall, investors will often flock to bonds yielding a higher interest rate, sending their prices higher.
• Inflation also serves as a risk, since higher inflation has the potential to wipe away investors’ returns.

Become a Bondholder for Secure Returns

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, time horizon and risk tolerance, and you should be good to go. 

Take a look at some of our favorite bond brokers.

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