The names Bond. Municipal Bond.
Crickets…Let’s start over.
Bonds are some of the most necessary and fundamental vehicles in the financial sector. They allow towns, governments, companies, and other groups to get funding. Bonds are essentially just I.O.Us to the person giving you money, the lender, that says you’re going to pay them back sometime in the future. They’re a fancy form of a loan that get’s companies and governments funding when they need it. What makes bonds different from loans is that they’re a form of security, in that you can buy a bond and start getting payments from the company that owes you. In essence, bonds are securitized loans.
Bonds will typically include an end date in their terms when the entire amount of money is due back to the issuer as well as terms for the interest payments to be made. These are some core principles about bonds to remember if you are looking for a general overview:
- They’re corporate or government debt issued by an organization that are trade able assets in the form of securities.
- Bonds are stable and referred to as a fixed income instrument. Their payments to holders don’t fluctuate over time like the value of stocks or dividend payouts do.
- Bond prices inversely correlate with interest rates. Since a low interest rate usually means the borrower is trustworthy, more people will want to own that bond because there’s little risk. Conversely, high interest rates infer a risky borrower, which increases the chances a bond becomes worthless, thus making them cheaper.
- Bonds have dates at which point all of their value must be paid back. This is called the maturity date, and beyond this point the bond ceases to exist.
Who issues bonds and why would you buy them?
Like we mentioned before, bonds are a way for companies or governments to raise money without giving up ownership of their company, which is what selling stock would do.
If a government needed money for a project, they could issue bonds, which investors can buy and be guaranteed payments from the government. Government bonds are typically seen as safe because there’s little chance the government won’t pay back the funds.
Companies, on the other hand, go bankrupt far more often, which would mean any bonds they issued would become worthless. If companies like Apple issued a bond, investors would eat it up because it would be seen as a very safe investment. However if a company like Blockbuster issued a bond to raise funds to open new stores, it would be a pretty risky bond.
You might be asking yourself though, why wouldn’t a company just go to a bank and get a loan? Well, chances are the bank can’t loan them the amount of money they need. In this case, companies have to turn to selling bonds to raise more capital. Bonds provide a way for individual investors and funds to become lenders to massive companies. Think of it almost as a way of crowdfunding corporate or government debt. Finding one bank to give you 20 million dollars would be hard. But finding 20,000 people to give you $1,000 would be a lot easier.
Now that we’ve covered why bonds exist and who issues them, let’s talk about the specifics of how they work.
How do Bonds Work?
Bonds are a form of security, just like stocks, except bonds are generally more secure and offer payments over time and have an end date, which is how investors make their money, rather than buying stock at one price and selling it higher later.
Bonds can be traded public ally, or privately, depending upon the way that they are set up.
While you might buy a bond in a similar way as a stock, the difference is that Bonds will come with terms and a plan for how you’re going to get your money back. Bonds will include the terms of the loan, the interest payments to be made over time, and the maturity date, the time at which the entirety of the funds need to be paid back to investors. Bond holders make their money through the interest payments the company makes to them, on top of paying back the original loan amount. The interest payments are called the coupon and the interest rate is called the coupon rate.
Most bonds are usually priced at either 100 or 1,000 dollars, called the par value. However, prices can fluctuate as people buy and sell them. If a companies issues a bond when their financials look good, but then something like, say a pandemic happens and the company loses all their revenue sources, the bond would fall in value as people wouldn’t want to own it. However since the bond was already sold to investors, in this case it would be the investors who would lose their money, not the company who issued the bond. This is the same way stocks and other securities work. It’s the risk of investing.
The value of a bond depends on these main factors: credit quality of the issuer, date until maturity, and the coupon rate compared to average interest rate of other bonds.
You could buy a bond and never plan to hold it until maturity. Rather you could buy a bond just to flip it in a few weeks if the price went up. Conversely, you could also just buy bonds and let them sit, collecting interest over time and making your money back slowly.
Let’s go through some more specific principles of Bonds.
Principles & Terms of Bonds
- Face Value: the amount of money the bond is worth at maturity. A face value of $1000 would mean at the maturity date, the issuing company would have to pay you back the full $1000.
- Coupon rate: The interest rate the issuer will pay. A 5% rate on a $1000 face value would mean you’d get $50 per year in addition to the $1000 at maturity.
- Coupon dates: the dates when the interest payments will be made.
- Maturity date: The end date of the bond.
- Issue price: The initial price the issuer set to buy the bond from them.
What causes a bond to have a higher interest rate?
The major determinants of the quality of a bond are the credit quality of the company or government (like a corporate credit score) and the time to maturity.
If the issuer has bad credit, the risk of losing all the bond’s value is greater, making the interest rate be higher in order for investors to be willing to take the risk.
If the maturity date is is further other, the interest rate will usually be higher too since it will take a longer time to get back the initial investment.
Companies get credit ratings from credit ratings agencies like Moody’s & Standard and Poor’s. Side note, these companies were also a main reason for the 2008 financial collapse, something we talked about in our post on Mortgage-backed securities here.
Bonds that are stable are called investment grade bonds. These usually are U.S. government bonds and strong profitable companies.
Bonds that are risky but just moderately, are called “high yield” bonds, or “junk” bonds. These bonds have greater risk of losing all their value, which means they’ll pay out a higher interest rate, but you could lose everything if the company goes bankrupt.
What are the categories of bonds?
The main categories of bonds are:
- Corporate bonds: Bonds from companies
- Municipal bonds: Bonds from states or cities.
- Government bonds: Bonds issued by a national bank or government.
- Agency bonds: Bonds issued by organizations that are affiliated with governments
There are also unique bond structures different from what we initially talked about. Those are:
- Zero-coupon bonds: Bonds that don’t pay interest but are rather sold at a discount and paid out in full at the end of their term. For ex. You could buy a $1000 bond for $900 and in 5 years get back the full $1000.
- Convertible bonds: Bonds that can be converted into stock down the line depending upon the stock price. This allows companies to pay less interest to bond holders that are willing to get stock down the line (instead of higher interest over time). For ex. A normal bond might have a 12% interest rate, and a convertible bond might have an 8% interest rate with the ability to be converted into stock if the stock hits a certain price down the line. It’s less payments for the company up front and could be attractive risk to the bond buyer.
- Callable bonds: These are just bonds that a company can buy back if they determine they can get a better interest rate down the line. Say their credit rating improves or interest rates decline, the company would buy back the bond and reissue the bond at a lower rate.
- Puttable bonds: These bonds allow the holders to sell the bond back to the company before maturity, which is a way for investors to protect themselves if they’re worried about the company not paying up down the line.
How are bonds priced?
Bonds’ prices fluctuate just like any other security on the market. Just like if a company starts doing really well their stock price might go up, so to might their bond price. If a company starts losing a ton of money, their stock price might go down, so too might their bond price.
In reality though, there’s a variety of technical factors that go into pricing bonds that we won’t delve into in this post. At the end of the day, bonds are just loans to borrowers that individual investors hold, not big banks. They can be fantastically stable investments that should make up a part of your investing portfolio. They can also be radically risking investments that can make or break you. Bonds are at the center of the way our modern economy functions, and understanding how they work is crucial to understanding investing.