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. 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.
Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.
Who Issues Bonds?
Bonds are debt instruments and represent loans made to the issuer. Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams, or other infrastructure. The sudden expense of war may also demand the need to raise funds.
Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development, or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide.
Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.
How Bonds Work
Bonds are commonly referred to as fixed-income securities and are one of the main asset classes that individual investors are usually familiar with, along with stocks (equities) and cash equivalents.
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 at par, 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.
HOW TO TRADE BONDS
Even if you don’t consider yourself an investor, you’ve probably heard of bonds. Bonds are a relatively simple product to trade. In fact, casual investors, and even those who don’t trade any other product, can buy bonds.
If you’re interested in the bond market, check out Benzinga’s guide and learn the ins and outs of how to trade bonds.
Types of Bonds to Trade
Municipal bonds are issued by state and local governments to fund the construction of necessary public projects like schools, housing, highways and sewer systems. There are 2 types of municipal bonds — general obligations bonds and revenue bonds.
Usually, these bonds are exempt from federal income tax. If you live in the jurisdiction where your bond is issued, it may also be exempt from state and local taxes. Keep in mind, the bond may be subject to federal, state and local alternative minimum tax.
Municipal bonds come with some risk because local governments are more likely to declare bankruptcy than the federal government.
Corporate bonds are issued by corporations to fund a large capital investment or a business expansion. The risk depends on the reputation and financial outlook of the issuing company. These bonds generally come with higher risk but offer higher reward. In some cases, you may see a convertible bond. This is a corporate bond that may be able to be converted into company stock.
Where to Buy and Sell Bonds
There are 2 basic ways you can buy and sell bonds.
- To buy a newly-issued bond from the U.S. government, set up an account with TreasuryDirect to get started.
- Find a brokerage. You can work with a specialized broker who handles bonds exclusively. You can work through an online brokerage to begin trading online. You can also buy treasury bonds through brokers, and some will even allow you to do this without paying them a commission.
If you work with a broker, you’ll receive a bulk information regarding the bond. Go in with an understanding of common terms to help you make a smart trade. Here’s a quick look at some of the basics:
Issuer: the government entity or corporation that issues the bond.
Price: the dollar amount at which the bond was last traded. This is often presented to you as a percentage of the bond’s par value — the price at which the bond was issued.
Coupon: this is the bond’s payment — not a discount for you.
Yield: the coupon divided by the bond’s price. Look at the yield to figure out what return you can expect from your investment.
Duration or maturity: the set number of years until your bond is fully-paid and stops accruing interest.
Yield to maturity: the yield you can expect if you hold your bond to maturity.
Bond rating: provided by private rating services, these letter grades indicate the credit quality of the bond.