Bond

When issued by a business, community, or the federal government, a bond functions similarly to a loan or an IOU. The issuer offers to pay the investor a certain rate of return for the usage of the money at predetermined intervals as well as the whole amount of the loan on a specific date.

Bond issuers

Bonds are loans to the issuer. Governments and enterprises use bonds to borrow money. Roads, schools, dams, and other infrastructure need government funding. War's unforeseen costs may also require funding.

Corporations borrow to grow, buy property and equipment, execute profitable initiatives, conduct R&D, and hire personnel. Large companies need more money than the regular bank can supply.

Bonds help solve this issue as they let multiple investors act as lenders. Thousands of investors can contribute to public debt markets. Long after a company has received financing, markets allow lenders to sell or purchase bonds from other investors.

Understanding Bonds

Bonds are one of the key asset classes individual investors are familiar with, along with stocks and cash equivalents.

Companies may offer bonds to investors to finance new initiatives, maintain operations, or repay debts. The borrower (issuer) issues a bond with the loan terms, interest payments, and repayment date (maturity date). Bondholders receive interest (the coupon) for lending money to the issuer. Coupon rate (basically the interest rates) determines payment.

Most bonds start at par, or $1,000 each bond. The market price of a bond relies on the issuer's creditworthiness, the period before expiration, and the coupon rate relative to current interest rates. When the bond matures, the borrower will receive its face value.

The initial bondholder can sell most issued bonds to other investors. Bond investors don't have to retain bonds till maturity. Borrowers often repurchase bonds as interest rates fall or their credit improves, allowing them to reissue bonds at a lower cost.

Bonds' Features

Most bonds have these essential features:

1. Face value. Face value (par value) is the bond's maturity value and the amount used to calculate interest. Say an investor pays $1,090 for a bond and later pays $980 for the identical bond. At maturity, both investors will get $1,000.
2. Coupon rate. 4% coupon rate means bondholders receive 4% x $1,000 face value = $40 annually.
3. Coupon date. Bond issuers pay interest on coupon days. Semiannual payments are the standard.
4. Maturity date. On the maturity date, the bond issuer pays the bondholder the face value.
5. Issuer price. Bond issuers sell bonds at the issue price. Bonds are often issued at par.

Credit quality and maturity determine a bond's coupon rate. Poor credit ratings increase the chance of default, hence these bonds pay more interest. Long-term bonds normally pay more interest. This higher remuneration is because bondholders face longer-term interest rate and inflation risks.

Standard and Poor's, Moody's, and Fitch Ratings rate a corporation and its bonds. Investment-grade bonds include U.S. government debt and reliable firms like utilities.

High yield or junk bonds are not investment-grade but not in default. These bonds have a larger default risk, hence investors want a higher coupon payout.

Interest rates affect the value of bonds and bond portfolios. Duration is interest rate sensitivity. New bond investors may be confused by the phrase duration, which doesn't refer to the bond's maturity date. Duration describes how much a bond's price changes with interest rates.

Convexity is the change in a bond's or bond portfolio's interest rate sensitivity (duration). Professionals generally calculate and analyze these parameters.

Bond Types

Bonds are marketed in four categories. Some platforms may also provide foreign corporate and government bonds.

1. Companies issue bonds. Bond markets offer more advantageous conditions and cheaper interest rates than bank loans for debt financing.
2. Governments issue municipal bonds. Municipal bonds offer tax-free coupon income.
3. Treasury bonds, for example. Treasury bonds with one year or less until maturity are called "Bills," those with one to 10 years are "notes," and those with more than 10 years are "bonds." Treasury bonds are government-issued bonds. Sovereign debt is government-issued debts.
4. Agency bonds, such as those issued by Fannie Mae and Freddie Mac, which are government-affiliated organizations.

How Bonds Work

Governments and companies sell bonds to investors to raise money. The seller borrows money by selling bonds. Buying bonds is an investment since it guarantees principal repayment and interest payments. Some bonds allow you to convert them into business stock.

The bond market tends to fluctuate inversely with interest rates, trading at a discount when rates are rising and a premium when rates are falling.

Example of Bonds
ABCD corporation needs $5million to build a new plant, but cannot borrow any more funds from the back. As an alternative, ABCD corporation can raise $1 million by selling investors bonds. ABCD offers to pay bondholders 4% annually for five years, semiannually. XYZ is offering 5,000 bonds, each worth $1,000.

Investing in Bonds
Bonds are less volatile than equities and are suggested for a balanced portfolio. Bond prices tend to climb when interest rates fall. Bonds held to maturity return the principle plus interest payments. Bonds are suitable for income- and capital-seeking investors. As people get older or near retirement, experts advise shifting portfolio weights to bonds.
Most online and inexpensive brokers give access to bond markets; you can buy them like stocks. Treasury bonds and TIPS are sold directly by the government through TreasuryDirect. Bonds can be bought indirectly through fixed-income ETFs or bond mutual funds.