What is a Bond - Types, Features & How It Works
Bonds have long been a cornerstone of financial markets, tracing their origins back centuries to facilitate capital accumulation. Initially used by governments to fund wars and infrastructure, bonds evolved into versatile instruments embraced by corporations and individuals seeking investment avenues.
They offer relatively stable returns and varying risk levels, helping to shape portfolios and global economies. As integral components of many investment portfolios, understanding their mechanics and diverse types are fundamental for investors navigating the intricate landscape of finance.
What Is a Bond?
A bond serves as a fixed-income tool representing an investor's loan to a borrower, often a corporation or government.
Analogous to an I.O.U., it outlines the loan specifics and payment schedule, commonly employed by corporations, municipalities, states, and sovereign entities for funding initiatives. Bondholders, essentially creditors, await repayment. Pertinent details encompass the maturity date for principal repayment to the bondholder and stipulations regarding the borrower's variable or fixed interest payments.
How Do Bonds Work?
Bonds, issued by governments and corporations, serve as a means to raise capital from investors. Selling bonds is akin to borrowing for the issuer, while buying them is an investment for the purchaser, returning repayment of principal and a stream of interest. Certain bonds provide additional advantages, like the option to convert into shares of the issuing company's stock.
The bond market typically reacts inversely to interest rates, with bonds trading at a discount during rate hikes and at a premium during rate decreases.
Types of Bonds
There are three main categories of bonds:
1. Corporate bonds, which are debt instruments issued by both private and public corporations. Examples of corporate bonds include:
Investment-grade bonds, characterized by a superior credit rating indicating lower credit risk compared to high-yield corporate bonds.
High-yield bonds, with a lower credit rating signifying higher credit risk than investment-grade bonds. These bonds offer elevated interest rates in compensation for the increased risk.
2. Municipal bonds, commonly referred to as "munis," are debt securities issued by states, cities, counties, and other governmental entities. Types of municipal bonds include:
General obligation bonds, issued by state or local governments and payable from either a general fund or specific taxes, such as property tax.
Revenue bonds, backed by revenues from a specific project or source, like highway tolls or lease fees. In some cases, revenue bonds are designated as "non-recourse," which implies that in the event of a dried-up underlying revenue source, bondholders do not have the right to make a claim on it.
Conduit bonds, issued by governments on behalf of private entities, like non-profit colleges or hospitals. Conduit borrowers repay the issuer, who then pays the bond interest and principal. If the conduit borrower defaults, the issuer is usually not obligated to pay bondholders.
3. U.S. Treasuries, issued by the U.S. Department of the Treasury on behalf of the U.S. government, carry the full faith and credit of the government, making them a secure and popular investment. Types of U.S. Treasury debt comprise:
Treasury Bills, short-term securities maturing in a four to 52 weeks.
Notes, longer-term securities maturing within ten years.
Bonds, long-term securities typically maturing in 30 years and paying interest every six months.
TIPS (Treasury Inflation-Protected Securities), notes and bonds with a principal adjusted based on changes in the Consumer Price Index. TIPS pay interest every six months and have maturities of five, ten, and 30 years.
4. Agency bonds, which encompass those released by entities like the Government National Mortgage Association (GNMA or Ginnie Mae), are commonly issued by specific U.S. government agencies, especially those linked to housing. The majority of agency bonds are liable to federal and state taxes.
Despite being generally of superior quality and easily traded, agency bonds may not yield returns that align with inflation rates. Certain agency bonds benefit from complete support from the U.S. government, making them almost as secure as Treasury bonds.
Features of Bonds
A bond constitutes a contract between the issuer and bondholders, with key features including issuer identity, maturity date, coupon, face value, bond price, and yield. These attributes shape a bond's cash flows, influencing an investor's anticipated and actual returns.
Issuer: The entity borrowing funds through bonds, determining investors' credit risk. Governments, organizations, and corporations issue bonds, assigned credit ratings by agencies. A single issuer may have multiple credit ratings for various debt issues.
Maturity Date: When a bond is redeemed, repaying the principal to investors. Bond maturities span from one day to over 30 years.
Coupon: The annual interest rate paid to bondholders, presented as a percentage of the face value, typically on an annual basis. For instance, a 4% coupon on a $1,000 face value yields $40 annually.
Face Value (FV): Also called notional or principal amount, the sum repaid to bondholders at maturity, expressed in currency (e.g., $5 million).
Bond Price: The current market value of a bond, represented as a percentage of its face value. Tradable in the secondary market, prices are expressed in percentages. For example, a bond priced at 102% with a $100 million face value would cost $102 million.
Bond Yield: The return on a bond investment, calculated by dividing the annual income by the current market price.
Varieties of Bonds
Bonds offer diverse options for investors, differing in interest payment structures, issuer recall features, and other attributes. Notable variations include:
Zero-Coupon Bonds (Z-Bonds)
Z-Bonds lack coupon payments, sold at a discount and pay the full face value at maturity. Examples include U.S. Treasury bills.
Convertible Bonds
These bonds enable conversion to equity based on specified conditions, providing investors the potential for stock participation.
Callable Bonds
Callable bonds allow the issuer to repurchase them before maturity, introducing a degree of risk for bond buyers, especially during rising bond prices.
Puttable Bond
Puttable bonds permit bondholders to sell back bonds to the issuer before maturity, serving as a protective measure against potential value decline or rising interest rates.
The intricate combinations of these features in bonds create unique investment opportunities, and investors often seek guidance from professionals for tailored solutions.
What is the Reason for the Buying and Selling of Bonds?
Investors choose to invest in bonds for the following reasons:
1. Bonds offer a reliable income stream by paying interest at regular intervals, typically every six months.
2. Holding bonds until maturity ensures the return of the full principal, making them a means of capital preservation alongside investment.
3. Holding bonds can mitigate the impact of market volatility associated with more unpredictable stock holdings.
Entities such as companies, governments, and municipalities issue bonds to raise funds for various purposes, including:
1. Generating operational cash flow.
2. Financing existing debts.
3. Funding essential capital projects like schools, highways, hospitals, and other initiatives.
Pros and Cons of Bond Investment
Advantages:
Safety: Bonds offer relative safety, acting as a stabilizing factor in a portfolio. They diversify assets and mitigate overall risk, despite some potential risks like issuer payment difficulties.
Fixed-Income: Bonds provide predictable, regular interest payments, making them an attractive asset for those seeking steady income, especially retirees.
Disadvantages:
Low Interest Rates: Safety in bonds corresponds to lower interest rates. Historically, long-term government bonds yield around 5%, compared to the stock market's 10% average annual return. (Source: What Are Bonds and How Do They Work?)
Risk Factors: While bonds are generally less risky than stocks, they aren't risk-free. Challenges may arise in selling bonds, especially if interest rates rise. Default risk, where the issuer fails to meet interest or principal obligations, and inflation affecting purchasing power are potential concerns.
If you're not ready to invest in any kind of bond but aim to optimize your idle cash, consider exploring Moomoo's Cash Sweep program.
FAQ for Bonds
1. How Bonds Are Priced
The market values bonds based on their unique attributes, subject to daily fluctuations influenced by supply and demand. While bonds can be held to maturity, they can also be traded in the open market, where prices may vary significantly.
Bond prices respond to changes in overall interest rates. For instance, if a fixed-rate bond promises a $100 annual coupon at a 10% interest rate and prevailing rates drop to 5%, the bond becomes more attractive, leading to a price increase. Conversely, in a 15% interest rate scenario, the bond price adjusts to maintain yield equilibrium.
2. What's the Relationship Between Bond Prices and Interest Rates
The correlation between bond prices and interest rates is such that when interest rates rise, bond prices decrease to align the bond's interest rate with the current rates, and conversely, when interest rates fall, bond prices increase. Another way to illustrate this principle is by examining the yield based on price changes.
For instance, if the bond's price drops from $1,000 to $800, the yield increases to 12.5%. This shift occurs because the fixed $100 return on an $800 asset results in a higher percentage yield ($100/$800). Conversely, if the bond's price rises to $1,200, the yield decreases to 8.33% ($100/$1,200).