A bond is a fixed income instrument, or simply put, an agreement between an investor and the company, government, or government agency that issues the bond.
Unlike stocks, an investor who buys a bond is not the owner of the bond issuer, rather the investor becomes a lender to a company, city, or government. Thus when an investor buys a bond, he/she is loaning money to the issuer in exchange for interest as well as the return of principal at maturity. This is because bonds traditionally pay the investor a fixed interest rate periodically and they are also known as fixed-income securities.
How Bonds Work
If an investor buys a bond, he/she is ‘loaning’ that money (the initial amount known as the principal) to the bond issuer, who is usually raising money for a project. This is unlike buying shares (stock) where a buyer becomes part of the company, to share in the proceeds of the company.
Who Issues Bonds
Bonds are commonly used by governments (at all levels) and corporations, to enable them to borrow money. The government needs to raise funds for projects that they have to execute, and this can be done via bonds.
Corporations on the other hand often borrow to grow their business, to purchase property and equipment, to undertake profitable projects, for research and development, or in hiring employees.
The Lifecycle of a Bond
- First, the company issues a bond, which is also known as bond origination.
- The bond issued, can then be bought by an investor. The investor in turn is loaning money to a company for a specified period of time.
- Thereafter, the investor receives regular interest payments from the issuer until the date of maturity. These periodic interest payments are known as ‘coupon payments’. The amount of the coupon payments is then determined by the coupon rate which is expressed as a percentage of the principal.
- Once the bond matures, the issuer, which is the company, repays the principal to the investor.
However, investors who wish to can sell their bonds, before the bond matures.
Some common basic characteristics are common with some bonds, they include:
The coupon rate:
This is the rate of interest the bond issuer pays on the face value of the bond which is expressed as a percentage.
The issue price:
The price at which the bond issuer is originally selling the bonds.
This is the money amount the bond will be worth at maturity. It is also the reference amount that the bond issuer uses when calculating interest payments.
The maturity date:
The 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.
These are the dates on which the bond issuer will make interest payments. The payments can be made at any interval, but the standard is semiannual payments.
Who are Bondholders?
Bondholders are investors who own bonds, they are considered creditors to the issuing organization. Bondholders can either decide to sell their bonds to other investors or get interest payments by holding the bonds, these interest payments are typically received semi-annually.
Categories of Bonds
Bonds are in four categories, and these are ones primarily sold in the market. Howbeit, there are also foreign bonds issued by corporations and governments on some platforms.
These are bonds issued by companies, who issue these bonds, rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.
Municipal bonds are issued by states and municipalities. Some municipal bonds, offer tax-free coupon income for investors.
These bonds, issued by the U.S. Treasury. These types of bonds, issued by the Treasury with a year or less to maturity are known as ‘Bills’, bonds issued with 1-10 years to maturity are known as ‘Notes’ while bonds issued with more than 10 years to maturity are known as ‘Bonds’. Now, the entire category of bonds that are issued by a government treasury is often collectively referred to as ‘Treasuries’, while government bonds issued by national governments may be referred to as sovereign debt.
These are bonds issued by government-affiliated organizations like Fannie Mae or Freddie Mac.
Bonds Vs Stocks – Difference
Both bonds and stocks are the option a company can decide on when it needs financing. A company can either decide to go public and make an initial public offering (IPO), selling shares of its company. When these shares (stock) is purchased by someone, the person becomes the legal owner of a portion of that company. When this happens, the company has used equity financing.
However, with a bond, the investor does not receive equity in the company. Rather, the company borrows from the investor, and the investor receives the interest payments and a principal of a bond, irrespective of how high or low the company’s stock price becomes. When this happens, the company has used debt financing.
Investing in Bonds
Bonds are typically sold over the counter (OTC). Those who are interested in buying bonds should buy from brokers who can better help them understand the fees associated as well as the commissions. When it comes to Treasuries, investors may buy bonds directly from the US government’s website, Treasury Direct. Brokerages like Vanguard and Fidelity also offer brokerage accounts, where investors can invest in Treasuries.
How are Bonds Priced?
A bonds price is equal to the present value of its expected future cash flows
The Yield-to-Maturity Formula
This is the bondholder’s return when the bond is held until maturity.
The YTM Formula can be calculated thus:
In order to calculate the yield to maturity, you must know that:
- The interest or coupon payment.
- The face value of the bond.
- The current market price of the bond.
- The number of years it takes for the security to reach maturity.
To calculate results, you can use a financial calculator or an online Yield to Maturity (YTM) Calculator to calculate your results.