If you’re new to the investing world, or you’re just getting started studying finance, then you’ve likely heard of “bonds”. Fundamentally, what is a bond?
What is a bond?
A bond is a fixed income security. Essentially, it’s a loan. Like many other loans, but with small differences.
We’ll focus on those intricate differences throughout this article.
But the focal point is that, when looking at bonds, perspective is key.
There’s the “buyers” (or investor) perspective, and then there’s the “sellers” (or issuer / borrowers) perspective.
Let’s start with the buyer’s perspective (likely you!).
The Bond Buyer’s Perspective
Bonds are “fixed income” securities that you can invest in to earn:
- Interest for a certain period of time,
- Lump-sum payment after a certain amount of time,
- Or both.
A typical timeline looks something like this…
In this example, the bond price is $1,125, and it pays $50 in interest (coupon payment) every year for a certain amount of time (“N years”).
This is followed by the lump sum payment after a certain amount of time on the bond’s maturity date (the “Nth” year).
What makes bonds really unique is the fact that unlike stocks, bonds have a legal obligation to pay the bondholder all the promised payoffs.
This holds across all types of bonds. So whether it’s a government bond / treasury bond, corporate bonds, municipal bond, etc.
In other words, the interest payment is mandatory. And so is the lump sum payment if that’s promised.
RELATED: How Do Bonds Work?
Contrary to popular belief, stocks actually have no obligation to pay you anything – not even dividends.
Now, bonds are called “fixed income” because the income you earn from them (either interest and / or the lump-sum) is fixed.
When you buy bonds, you’ll know exactly what interest and lump sum you’ll earn, right from the word go.
Of course, since you’re earning these payoffs, someone must be paying it! That brings us to the other side of the coin…
The Bond Issuer’s Perspective
From the seller’s / bond issuer’s perspective, a bond is just a loan.
They issue this type of debt instrument to investors in exchange for cash today.
Issuers, for the most part, tend to be governments and large corporations.
In A Nutshell…
With both perspectives combined, it’s clear that bonds are nothing but contracts.
You as the buyer agree to pay the seller something today (the “bond price”, see bond characteristics below).
In exchange, the seller / issuer commits to paying you either interest and / or the lump-sum, depending on the type of bond issue, and what’s in the terms of the contract.
Related: Bond Valuation Course
This Article features a concept that is covered extensively in our course on Bond Valuation Mastery.
If you’re interested in learning and mastering Bond Valuation, then you should definitely check out the course.
Why Buy Bonds?
Apart from the fact that they offer known payoffs, bonds also tend to be less risky compared to stocks. Generally speaking, they’re safer investments.
This is especially true when you consider investment-grade bonds, but is arguably less true for high-yield bonds (aka junk bonds).
The bond market as a whole also tends to be far less volatile vis-a-vis the stock market.
This means that by buying bonds, you put yourself in a place where you can invest in other riskier assets, without exposing yourself to as much risk as if you’d invested in those riskier assets alone.
This is because of the effects of “diversification” (in English, the benefits of not putting all your eggs in 1 basket).
Consider a scenario where you invest $1,000 in a stock, “ABC”.
Let’s assume that in a year’s time, the stock declines by 50%.
This would mean you’d lose half your money since your shares would be worth $500.
Now consider if you’d invested $500 in the stock, and $500 in a bond.
Since bond prices don’t tend to fluctuate as much, we can make a (simplistic) assumption that the price remains constant.
In that case, your stock would be worth $250 (still down 50%), the bond would remain priced at $500, so your portfolio would be worth $750.
In other words, you’d have lost 25% of your money, instead of 50%.
Of course, if the stock increased by 50%, you’d earn more if you’d invested $1,000 in the stock (instead of $500).
But when you’re investing, generally speaking, the upside will take care of itself.
It’s the downside risk that you want to manage.
Still here? Great. Let’s get into the specifics…
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Bond Characteristics
Recall that bonds are “fixed income” securities that you can invest in to earn:
- Interest for a certain amount of time,
- Lump-sum payment after a certain amount of time,
- Or both.
This is a “non-technical” definition. In reality, we use significantly more fancy / sophisticated terms to describe bond characteristics.
All bonds have 4 characteristics, and most have 5.
#1: The Coupon Payment
The coupon refers to the interest paid by the bonds.
Buying a coupon-paying bond thus entitles the bond investor to earn interest (“coupons”) for a certain amount of time.
More on the “certain amount of time” maturity date in a bit.
If we take the coupon and divide it by the lump-sum payment (“The Par” (see below)), then we get the “Coupon Rate”.
Crucially though, the coupon rate is NOT the interest rate of the bond.
That title is reserved exclusively for what we call the “Bond Yield”. We’ll leave this for the last characteristic.
For now, let’s look at the lump-sum payment which is…
#2: The Par Value
The Par value is the lump-sum payment paid after a certain amount of time. And because jargon makes us sound very clever, we also refer to it as…
- Face value
- Nominal value
- Redemption value
- Principle
The Par Value is always paid at the end of the bond’s lifetime, which takes us to…
#3: The Maturity Date
Maturity date (aka Time to Maturity) is the lifetime of bonds. If a coupon paying bond has a 10 year maturity, it means that it’ll pay Coupons every year for 10 years, followed by the Par at maturity.
Remember we said the interest is paid for a certain amount of time? Well, it’s paid up until the bond matures.
That’s also when the Par value is paid.
A generalised timeline of a bond can then be expressed like so…
C is a generally accepted abbreviation for the Coupon, Par for the Par Value, and N for the bond’s maturity date.
#4: The Price
Bonds aren’t free. The amount you pay to buy / sell it and become a bondholder is the “price” (aka Market Price). This isn’t necessarily what the bond should trade at – that’s the Fair Price – rather, it’s what the bond is trading at.
If the price of a bond is greater than the fair price, we say it’s overvalued. And likewise, if the price is lower than the fair price, then it is undervalued.
Estimating the price requires the coupons, Par, maturity, and most importantly, the yield.
#5: The Yield To Maturity
The yield is perhaps the most important characteristic of bonds. Did we mention we love jargon in finance? The yield is also called…
- Yield To Maturity
- Effective Rate
- Interest Rate
- Effective Interest Rate
- Required Rate
- Internal Rate of Return
The bond yield shows you the return you can expect to earn from the bond, on an annualised / quarterly / monthly basis, given the time value of money.
From the bond issuer’s perspective, the bond yield can be seen as the cost of raising debt finance (i.e. the cost of debt).
Put differently, it’s the cost of bond financing.
When pricing bonds, we discount the future cashflows (Coupons and Par) by using the Yield as the appropriate discount rate.
Note that, importantly, a bond’s Yield to Maturity is the same as its Internal Rate of Return. This is a crucial fact that’s used to value bonds.
RELATED: How to Calculate IRR
Remember we said some bonds only pay interest, others only pay a lump-sum, and still others pay both?
This means that some bonds don’t have a Coupon, and others don’t have a Par, meaning those bonds only have 4 characteristics.
For instance, a Zero Coupon Bond only pays the bond investor the par value at the maturity date. It does not make any coupon payment whatsoever.
A Perpetual Bond on the other hand only pays the coupon (since there is no maturity date!).
Wrapping Up
Alright, you’re hopefully now familiar with bonds are, and more importantly, how these debt instruments actually work.
Remember again, the main / focal point is that perspective is key!
If you’re looking to go beyond the basics and learn how to value bonds from scratch, feel free to check out our other articles and the course below.
Related Course: Bond Valuation Mastery
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