What Is a Bond?
A bond is a certificate of debt issued by a company. They are purchased by an investor, making them small scale loans held by individuals. Bonds are securities, like stocks. However, instead of buying a piece of a company in return for equity ownership, bonds provide their return on investment through interest paid on the principal of the bond.
How Does a Bond Work?
Bonds have three components: the principal, the coupon rate, and the maturity date. These 3 components are used to calculate a bond’s yield. The principal of the bond, also called its face value or par value, refers to the amount of money the issuer agrees to pay the lender at the bond’s expiration. The principal of a bond is usually either $100 or $1000, but on the open market, bonds may also trade at a premium or discount on this price. The coupon rate is the percentage of the principal paid back to the investor as interest. Whatever the principal is, the coupon rate is a percentage of that value. The bond maturity date is the date on which the principal must be paid back to the bondholder. The bond issuer will make interest payments while holding onto the investor’s money, and will also pay back the principal of the bond. Depending on whether the bond was sold at a discount or a premium, the principal of the bond may be slightly higher or lower than the original investment.
A bond’s yield is a measure of its return. The yield is calculated using the bond’s current market price (not its principal value) and its coupon rate. For example, a bond purchased at its face value of $1000 with a coupon rate of 5% returns $50 annually, so its yield is 5%. If the bondholder later sells the bond to another investor at a premium for $1100, the bond will still return $50 annually, but its yield will be lower. $50 is 4.5% of $1100, so the yield to the new investor is only 4.5%. If the same bond were to be sold for $900, the yield would be 5.5%. Therefore, since the maturity date and coupon rate remain constant, the yield only changes based on the market price for a given bond.
Other Factors That Affect Prices and Coupon Rates
A bond’s coupon rate can also be affected by the issuer’s credit quality and the time to maturity. Credit quality refers to an estimation of how likely the issuer is to be able to pay the dues of a bond. Poor credit quality is an indicator that a bond issuer has a high chance of defaulting on the bond, or being financially unable to pay it back. If a company has a poor credit quality, then the bonds it issues will have a higher than average yield to compensate for the risk. In this event, even if the prevailing interest rate on bonds is 5%, a company might issue bonds with a coupon rate of 7% to encourage investors to buy riskier debt. While a high rate of return might look good on paper, an unusually high coupon rate indicates a riskier bond. Time to maturity is also a risk factor for investors, because the longer a bond is active before being repaid, the more subject it is to changes in the interest market, the credit quality of the issuer, and the influence of unexpected variables.
Why a Bond Price Might Sell at Premium or Discounted rates (Pro Tip)
A bond’s price will fall or rise to bring it in line with competing bonds on the market. For example, a $1000 bond at a 5% coupon rate has a lower yield than the same bond at a 6% rate. To make the first bond as enticing as the second, the price needs to fall until the yields of both bonds are identical. In this case, the first bond would have to sell at about $835 for a yield equal to 5.98%. A general rule of thumb is that when prevailing interest rates are higher than the coupon rate of a bond, it will sell at a discount (less than par). When interest rates are lower, it will sell at a premium to par value. Because of this, bond prices are said to be inversely proportional to prevailing interest rates.
Investing in bonds is typically lower risk than investing in stocks. Bonds, also called fixed income instruments, are certificates of debt sold to investors to raise capital. Bonds pay a fixed interest payment on top of repayment of the principal upon maturity. Bonds will usually make up a portion of a healthy investment portfolio.
Types of Bonds
While there are many varieties of bonds available, there are two main categories of quality: investment grade bonds, and junk bonds. Investment grade bonds are historically safe bonds with a low interest rate (usually issued by governments) that are very low risk. Junk bonds are higher risk, and have correspondingly yield a higher interest rate.
Treasury bonds are debt vehicles issued by the US treasury to raise capital for government spending. They are historically among the safest bonds available, being backed by the full authority of the issuing government. Treasury bonds have maturities of between 10 and 30 years (they should not be confused with treasury bills or notes, which have significantly shorter maturities).
An example of a simple, investment grade bond is a US treasury bill. They have an interest rate determined by the standard interest rate issued by the Federal Reserve and maturities of five years or less. Government bonds tend to have relatively low interest rates in exchange for their safety, while corporate bonds may be more variable.
What is a Government Bond?
A government bond is a debt instrument issued by a government to raise capital to finance activity. In the US, the government issues treasury bonds, treasury notes, and treasury and bills, which are bonds with varying maturities. Government bonds are considered the safest possible bonds because they are backed by the authority of the issuing government.
What is a Bond in Accounting?
When accountants look at bonds that their company has issued, bonds payable are considered liabilities. They are often recorded as long term liabilities on the balance sheet, but if they are payable within one year, they are recorded as current liabilities.
Set Your Plan in Motion
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What Is a Bond FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.