ETF Investing and Portfolios - Money

Investment Basics – An Introduction To Bonds

What is a Bond?

A bond, as the name suggests, binds two parties–a borrower and a lender–together in a contract. While perhaps not commonly thought of in this way, a bank loan is a bond. The bank agrees to lend money to the borrower according to defined terms. These specify such things as the amount being loaned, the term of the loan, the interest rate, and the amount and frequency of payments. Since a contract is signed, there is also a promise to pay on the part of the borrower.

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However, for the purposes of our discussion, the word “bond” is more typically used to describe a type of security issued by either a governmental agency or a business to raise needed funds to undertake a project. For example, a city may need to raise money to renovate school buildings that are seismically unsafe. Or a business may need to raise money to build a factory to manufacture their products.

Characteristics of a Bond

In general, bonds have the following three characteristics:

  1. A defined term, or date of maturity.
  2. A specific amount that the issuer promises to pay at the end of the term. This is known as the face value.
  3. A series of payments, called coupons, that will be paid at defined intervals

For example, a business may offer a “10-year bond, with a face value of $1,000, and a 6% coupon paid annually.” This means that a buyer willing to purchase this bond for $1,000 today is promised payments of $60 each year and then to receive the initial $1,000 back at the end of 10 years.

Additionally, all terms are fixed by the contract. Unlike a stockholder, if the business does extremely well and earns vast profits, a bondholder does not participate in those profits except for being repaid according to the terms of the bond. In the example above, a buyer who holds the bond until maturity essentially earns a return of 6% on their investment. On the other hand, since a bond includes a promise to pay, bondholders are paid before stockholders if a business runs into difficulty. In this sense, bonds might be considered less risky than stocks. However, they are not without risk, as will be discussed in the next section.

Finally, bonds can be sold on the open market. So, for example, if a bondholder encounters financial difficulty and is forced to sell the bond before the maturity date, he can do so. However, he may not be able to receive the same $1,000 he paid for the bond. This will also be discussed in the next section.

Risks of Bonds

In general, there are two types of risks with bonds:

  1. Interest rate risk
  2. Default risk

Interest rate risk refers to the fact that interest rates move up and down over time. Such changes affect the value of bonds. For example, think of the bond in our example above in an environment where interest rates rise to 10%. If a buyer can now purchase a bond with a face value of $1,000 and a 10% coupon, they will not be willing to pay $1,000 for this bond, since it only pays a 6% coupon. Therefore, a bondholder who is forced to sell the bond before maturity will receive a price less than $1,000, resulting in a loss. On the other hand, if interest rates fall, the value of this bond should rise.

Default risk refers to the perceived possibility that the lender may not be able to repay either the coupons, the face value, or both. Typically, this is why a business will have to pay a higher interest rate than would the U.S. Government for a bond with otherwise identical terms. Rightly or wrongly, the perception is that the government will make good on all the terms of the bond, whereas a business may not be able to do so due either to poor management, a severe downturn in the economy, or other factors beyond their control. Bonds are typically rated by various rating agencies. These ratings are intended to evaluate how great the risk of default may be for a given bond.

Interestingly, both these risks are magnified the longer the term of the bond. This is why, typically, interest rates on long-term bonds (i.e. 10 years) are higher than short-term bonds (i.e. 1 year).

UPDATE: Following the publication of this article, I wrote an article for Seeking Alpha that discusses two more advanced concepts; reinvestment risk and duration, as well as how these play out in four top-quality bond ETFs.

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