Fixed Income

Bond Basics

What are bonds?

Bonds are debt securities issued by corporations, governments and municipalities. Bonds are similar to IOUs: investors lend money to a corporation and in return receive interest payments. The corporation is obligated to return the principal to investors on a predetermined date in the future. When purchasing bonds, investors become creditors of the issuer, therefore, having priority claim on the issuer’s assets in the event of bankruptcy.

Bond Characteristics

– Par or face value is the bond’s denomination and the amount returned to the investor upon maturity. Par is not the price of the bond. The price fluctuates throughout the lifetime of the bond. If the price is above par, the bond is selling at a premium. If the price is below par, the bond is selling at a discount. Price is generally quoted in percentage of face value. For example, a price of 98 means 98% of the bond’s $1,000 par value or $980.

– Coupon rate (or just coupon) is the interest rate paid to investors as compensation for the loan. Coupon payments are generally made semi-annually unless otherwise stated. Many investors depend on this predictable income.

– Maturity is the term of the bond’s life. Bonds range in maturity from three months to 100 years. On the maturity date, the bond's face value is repaid to the investor and the interest payments stop.

– Call features are issued with some bonds and give the issuer, at its discretion, an option to redeem the bond (pay back the principal) prior to the maturity date. The bonds become callable when the situation is most beneficial for the issuer. In general, bonds are called when market interest rates fall, allowing the corporation to issue new bonds with a lower coupon rate. For taking on the risk of a possible call prior to maturity, investors are usually compensated with a potentially higher return at the time of purchase.

– Credit rating is a reflection of a company’s credit worthiness. Just like individuals, corporations with poor credit have difficulty finding financing at lower costs. “Junk bonds” or high-yield bonds have a higher risk of default and, therefore, must offer investors a higher stated return on the borrowed money. High-yield bonds (below investment grade) are not suitable for all investors.

Price/Yield Relationship

Yield is the annual rate of return investors earn based on a bond’s coupon rate and its current market price. When interest rates rise, the price of an existing bond falls because its coupon becomes less attractive for potential investors. The opposite happens when interest rates fall. Hence, the price of the bond and its yield have an inverse relationship.

Next: Types of Taxable Bonds