Introduction to Bonds
What are bonds?
A bond is a loan in the form of a security where the bond buyer (the lender) lends money to the bond issuer (the borrower). Interest payments are made at fixed intervals for a predetermined amount of time and then the principal (the original money borrowed) is paid back at maturity. The term "bond" is technically reserved for debt issues where the repayment term is more than 10 years. If the repayment term is more than 1 year but not more than 10 years then the debt is called a "note". If the repayment term is 1 year or less then the debt is called a "bill".
How are bonds issued?
The process for issuing corporate bonds is similar to issuing stock. An investment bank (or a group of investment banks forming a syndicate) underwrites the bond offering by buying the bond offering and re-selling them to investors. Government bonds, on the other hand, are typically auctioned off.
Why do companies issue bonds?
Most companies issue bonds in order to raise funds to fund projects that require capital. When a company decides it wants to raise money it has to decide whether to do it by issuing stocks or borrowing money by issuing bonds or getting a bank loan. The advantage to issuing bonds over stock is that the company doesn't have to give up any partial control of the company or give up a portion of profits. The downside is that they have to pay back the money, with interest. Having to make debt payments each month will lower the profits of the company as long as they have debt outstanding as well as possibly raise the risk that the company may fail due the higher expenses.
Why do people buy bonds?
Most individuals buy bonds because they offer a decent return with relatively little risk. But because bond prices can sometimes fluctuate a lot, some investors buy bonds because they believe the bond market will be going up and they can sell the bonds at a profit.
Who issues bonds?
- Federal government. These bonds, called "Treasury bonds", are government bonds issued by the United States Department of the Treasury and are used to pay for Federal government expenses that not covered by taxes.
- State and municipal governments. These are called "municipal bonds" or "muni bonds" for short. These are bond issued by a state, city, county, local government, or one of their agencies (like a school districts or airport).
- Corporations. Corporate bonds are issued to meet the long-term capital needs of corporations. Sometimes corporate bonds carry "covenants", which are conditions placed on the borrower in order to get the loan. For example, in order for a company to get money they may have to agree to keep a certain amount of cash on their balance sheet.
Bond terminology
- Face Value. The principal, or the amount borrowed.
- Maturity date. The date by which the borrower has to pay back the money.
- Coupon. The coupon is the amount of the interest payment, in dollars. It is called this because the physical bonds used to come with coupons had to be cut off and sent in to get the interest payment.
- Coupon rate. The coupon rate is the yield that the bond had when it was issued. This is not the interest rate you will get if you buy the bond.
- Current yield. This is the interest rate you will get when you buy the bond. It is calculated by dividing the annual coupon payments into the current bond price.
- Tax-equivalent yield. This is the yield of a muni bond as if it were taxable. This is used to compare the tax-adjusted yields of muni bonds to taxable bonds.
- Basis point. The smallest measure used in quoting yields on bonds. One basis point is equal to 0.01%. For example, if a bond’s yield rose from 5.50% to 5.65% then the yield has risen 15 basis points.
- Point. A point is equal to 1% of the face value of a bond. Therefore, when a bond is "up two points" that could mean a bond went from 84 up to 86 or 110 up to 112.
- Par value. This is the starting price of the bond when it was issued. Almost all bonds are issued at a par value of 100.
- Bond rating. A measure of the quality and safety of a bond as defined by a bond rating agency.
Bond risks
- Default Risk. This is the risk that the borrower will not be able to pay back the principle or make interest payments.
- Interest Rate Risk. The risk that bond prices will fall due to a rise in interest rates. The longer the maturity of a bond, the greater the interest rate risk will be because longer-term bonds are more sensitive to interest-rate changes. Sometimes this is called Duration Risk.
- Liquidity Risk. The risk that there won't enough buyers if you want to sell. For example, when Long Term Capital Management bought Russian bonds and the Russian bond market dropped, they had trouble finding buyers because there was no liquidity in the market.
- Market risk. This is due to the bond market in general dropping due to investor's preferences about asset allocation or other reasons.
- Inflation risk. Inflation devalues money so that the future interest payments will be worth less. Also, inflation leads to a rise in interest rates, which devalues bonds.
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