What Is a Bond?
Shakespeare may have suggested to “Neither a lender nor a borrower be,” but he didn’t have access to credit scores and ratings in the 17th century, did he? If he did, he could have been living off a stream of interest payments instead of making up silly stories.
Quick take: A bond is a loan that pays bondholders interest and principal. Bonds have a bit of jargon attached to them, but if you’ve borrowed money, most will be familiar to you already. Bonds can be held until their maturity date or traded on the market.
- A bond’s principal value (“face value”) is the amount that will be paid to the bond’s owner at maturity — that’s the date the bond issuer has agreed to pay the face value back to you. Most corporate bonds have a $1,000 face value.
- The coupon is the annual interest rate the bond pays on the principal value.
- Most bonds pay interest semi-annually. Some bonds (zero-coupon bonds) only pay interest at maturity.
- Bonds can sell at a discount, premium, or equal to their principal amount (par value) due to changes in market interest rates or the creditworthiness of the company. A bond’s yield is a better measure of a bond’s return than the coupon rate, because it accounts for premiums, discounts, and reinvesting interest.
Tell me more! One of the most important features of a bond is its promise to pay a principal amount on a specific date. That promise relies on the four “Cs,” which are capacity, collateral, covenants, and character. A borrower should have the financial ability to pay interest and principal on time, assets pledged against the loan, a document that ensures the company will maintain its capacity to pay, and a past history of honoring its obligations. Those are hard for investors to judge, which is why most retail investors rely on credit ratings from agencies like Moody’s and Standard & Poor’s. A “triple-A” rating is the safest. The lower the credit rating, the more yield investors should demand for risking their money in a loan. High yield bonds (junk bonds) have low credit ratings and high yields.
One more thing: Though the principal amount and coupon rates of a bond are fixed, the price of a bond will fluctuate, sometimes by quite a bit. Here are a few rules of thumb about how a bond’s price will move:
- When interest rates go up, the value of a currently trading bond will decline, which makes its yield go up (and vice versa).
- When a bond’s creditworthiness increases, its price will go up, and its yield will go down (and vice versa).
- The longer the time until maturity, the greater the price change with the same change in interest rates.
- The higher the coupon, the lower the price change will be with the same change in interest rates.
The most important thing to remember is that the longer the maturity of the bond, the more exposure you have to falling and rising interest rates. That’s why bond funds often come in long-term or short-term flavors. Short-term bond funds typically have lower interest rate risk, but less risk often means less yield.
Stock prices are driven largely by interest rates and the bond market. Investors always have a choice between the relative safety of bonds or the higher potential return of stocks. When interest rates increase, companies have to pay more interest to borrow money and investors are more tempted to lock in high yields through buying bonds, which drives stock prices down.