What is a bond?
Along with stocks, ETFs, and other types of investments, bonds are used by many investors, typically to add income and diversification to a portfolio. Let’s explore the basics of bonds.
A bond is a security that represents an agreement to repay borrowed money. In short, it’s a type of loan. A typical bond has these key characteristics:
- An issuer. This is who is borrowing the money. An issuer could be the United States government, a state or municipality, or a corporation.
- Principal. This is the amount of money that the issuer is borrowing. Issuers may borrow hundreds of millions of dollars at a time, so the principal is divided into units, each one called a bond. Bonds are typically issued in units of $1,000 each. It’s important to know that after a bond is issued, the first buyer can resell it on what’s known as the secondary market. In fact, most investors buy bonds on the secondary market, not from the original issuer.
- Maturity date. This is the date when the issuer must repay the principal to whoever owns the bond. When a bond is issued, its maturity date might be only a few months in the future, or it might be as many as 30 years down the line.
- Interest rate, also called coupon rate. As with any loan, the borrower pays interest on the money that is loaned to them. Most interest payments are semiannual with the principal—i.e. the face value of the bond—repaid at maturity along with the final interest payment. The rate the issuer pays is usually set at the time the bond is issued. On the other hand, the rate of interest that you earn if you own the bond depends on the price you pay for the bond when you buy it.
Let's look at an example. If a company issues a $1,000 bond with an interest payment of 5%, the company will pay the bond holder $50 per year for the life of the bond, usually in two semi-annual $25 payments. Then, at maturity, the bond holder would be paid back the entire $1,000 principal.
Bonds are also known by the term fixed income, as the coupon payments are usually fixed over a specified period of time.
When you’re choosing a bond, the issuer’ s credit ratings are a key factor. Businesses with lower credit ratings are generally considered riskier, so they must pay more interest to attract buyers. Therefore, lower rated bonds pay higher interest rates. Buying a variety of bonds with different interest rates and risk profiles can help keep your bond portfolio diversified.
Although there are high-risk bonds, most bonds are generally considered safer than stocks. Adding even a small amount of bonds to your mix of investments can help you diversify and significantly reduce volatility in your portfolio. Not only that, US Treasury and municipal bonds can offer investors potential income tax advantages.
When you purchase a bond on the secondary market, the price is dictated by supply and demand in the market for that bond. As a result, you could purchase the bond at face value (known as par), at a discount, or at a premium.
- $1000 bond purchased for $980 is at a discount
- $1000 bond purchased for $1000 is at par or face value
- $1000 bond purchased for $1050 is at a premium.
This is the annual rate of return on the bond. It can change based on whether the bond was bought at a discount, at par, or at a premium.
- When purchased at a discount, the current yield is higher than the coupon rate
- When purchased at par, the current yield is equal to the coupon rate
- When purchased at a premium, the current yield is lower than the coupon rate
Yield to maturity
This is the expected yield if the bond is held to maturity and takes into account market price, par value, coupon rate and time until maturity.
- When purchased at a discount, the yield to maturity is higher than the coupon rate and current yield
- When purchased at par, the yield to maturity is equal to the coupon rate
- When purchased at a premium, the yield to maturity is lower than the coupon rate and current yield
Yield to worst
This is a bond’s lowest possible yield if the issuer does not default but the bond is retired before its maturity date, allowing the issuer to avoid some interest payments. Some bonds have provisions that permit this.
Yield to call
This is the total return if the bond is held only until its call date. A call date is the most common provision that lets an issuer retire a bond early—i.e. pay the bond’s face value to the bond holder before the maturity date.
A see-saw diagram helps to visualize the relationship of the various yields and purchase prices.