What is a bond?
Investors use bonds to add income and diversification to their portfolios.
A bond is a security that represents an agreement to repay borrowed money, 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 semi annual with the face amount 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 fixed over a specified period of time.
When you’re choosing a bond, the issuers 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, many government issued bonds pay interest that is free from federal or state income taxes.
When purchasing a bond on the secondary market, you can purchase the bond at a price dictated by supply and demand of the market for that bond. As a result, you could purchase the bond at a discount, at par or at a premium.
- $1000 bond purchased at $980 is at a discount
- $1000 bond purchased at $1000 is at par or face value
- $1000 bond purchased at $1050 is at a premium.
Stated rate on the bond’s coupon, also called the coupon rate
Annual rate of return on the bond. This number 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
Current yield = annual interest/market price
Yield to maturity (also called basis)
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 couon 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 current yield and the coupon rate
Yield to maturity = annual interest – annual amortization/(market price + par value)2
A see-saw diagram helps to visualize the relationship of the various yields and purchase types