What is a Bond?
A bond is an IOU. It is issued by a government or private enterprise in exchange for cash.
The person or entity purchasing the bond is known as a bondholder. Bondholders are paid a fixed rate of interest at regular intervals until the bond’s maturity date, at which time they are repaid the bond’s full principle amount.
Anatomy of a Bond
Bonds have time frames leading up to maturity which are referred to as “terms.” Once a bond reaches the maturity date, the principle is repaid in full. Corporate bonds generally have terms on the shorter timescale. They may reach maturity in as little as one year, and often don’t have terms longer than five years.
Treasury bonds (known as “treasuries”) often have much longer terms. It is common to see treasury bonds with terms spanning 10, 20, or 30 years, though short-term treasuries are available as well. In both cases, bondholders are paid out fixed interest payments known as coupon payments.
The fixed interest and constant nature of bond coupon payments makes them distinct from stock dividend payments. This fixed interest rate is set as a percentage value of the bond’s face value—for example 2 percent—and it is guaranteed.
Treasury bonds issued by the US government are considered “riskless.” They are backed by the full faith and credit of the US government meaning they have an extremely high credit rating. Bonds, in general, are considered lower risk than other forms of investment because they are less susceptible to price swings and other forms of market volatility.
Low risk also tends to mean low reward. While bonds are considered safer investments, they often provide a low return as well. Additionally, the longer the terms of a bond (or the further in the future the maturity date) often the higher the interest rate.
Not all bonds are as “riskless” as treasury bonds. Bonds are rated by three main rating services—Moody’s, S&P, and Fitch. The better a bond’s rating, the more reliable the entity that issues that bond is considered. Reliable, highly-rated bonds often offer lower interest rates. On the other hand, bonds with lower ratings will pay higher interest rates but with higher payouts comes an increased risk of default.
How Bonds Work
Bonds can be bought at auction when they are first created. During the auction period, investors bid on the interest rate. As bidding on a given bond increases the interest rate is driven lower. Higher demand lowers bond interest rates due to the competing interests of bond issuers and those of investors.
Bond issuers would prefer to give low-interest bonds; low-interest bonds mean less money paid during the bond’s term period. Bondholders, of course, want a higher interest rate which results in higher regular payments up to the bond’s maturity date.
Not only can bonds be bought at auction, but they can also be purchased in the aftermarket. Purchases that are made after the auction period do not affect the bond’s interest rate, however, the interest rates offered by similar bonds that are currently at auction will have an impact on the purchase price.
I want to by a corporate bond from Company XYZ. The principle is $1,000 with five-year terms. This bond was issued in January of 2015, and at that time was issued with an interest rate of 2.5 percent.
Today, Company XYZ is issuing five-year bonds with interest rates of 2.1 percent. Because the bond I want to purchase is approaching its maturity date and it has a higher interest rate than what can be bought at auction today from Company XYZ, the bondholder will likely charge me a higher price to part with the 2015 bond from Company XYZ.