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Bonds and Fixed Income Products
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Fixed income markets are larger with more big money than the stock markets. Retail investors looking for safe retirement investments also look at bonds. Here's how the fixed income markets work and how you can get in on the action.
What is a Bond
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. A bond has an end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments that will be made by the borrower. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.
How Bonds Work
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
The initial price of most bonds is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.
Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower's credit has improved, and it can reissue new bonds at a lower cost.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
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Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium $1,090 and another purchases the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
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Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
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Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.
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Maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
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Issue price is the price at which the bond issuer originally sells the bonds.
Two features of a bond - credit quality and time to maturity - are the principal determinants of a bond's coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate because the bond holder is more exposed to interest rate and inflation risks.
Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor's, Moody's, and Fitch Ratings. The very highest quality bonds are called "investment grade" and include debt issued by the U.S. government and very stable companies, like many utilities. Bonds that are not considered investment grade, but are not in default, are called "high yield" or "junk" bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.
Bonds and bond portfolios will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called "duration". The use of the term duration in this context can be confusing to new bond investors because it does not refer to the length of time the bond has before maturity. Instead, duration describes how much a bond's price will rise or fall with a change in interest rates.
The rate of change of a bond's or bond portfolio's sensitivity to interest rates (duration) is called "convexity". These factors are difficult to calculate, and the analysis required is usually done by professionals.
Bond Issuers
There are three main categories of bonds.
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Corporate bonds are issued by companies.
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Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
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Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called "Bills"; bonds issued with 1 - 10 years to maturity are called "notes"; and bonds issued with more than 10 years to maturity are called "bonds". The entire category of bonds issued by a government treasury are often collectively referred to as "treasuries."
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