What are bonds?
A bond is a financial product that allows an investor to lend money to an issuing institution. In exchange for their ownership of a bond, lenders pay an interest rate, also known as a coupon rate. Simply put, it is a form of a loan. By definition, the buyer of a bond is the lender, while the issuer is the borrower. Issuing bonds is a way in which institutions can finance their operations.
The money that a company receives by issuing bonds is counted as a loan. In general, the amount must be repaid over time on a date agreed upon in advance. Until this date, the bondholder (lender) issues interest payments. Issuing institutions can be companies, municipalities, or even national governments.
What do you need to know about bonds?
There are three key elements of a bond that are important to understand: coupon, face value, and maturity date
Coupon:
The coupon (or coupon rate) is the interest rate paid by the issuer of a bond. For example, a bond with a face value of $1,000 and a 5% annual coupon rate pays out $50 per year. The word coupon originates from the time when bonds had a paper coupon attached to them, which could be submitted to receive payment.
Nominal value:
A bond has a nominal value (par value in English). The face value is the amount paid to the bondholder when the bond matures. If the interest rate rises higher than the coupon rate, the bond trades below par. When the interest rate falls below the coupon rate, it is traded at a premium or above par. Where Is The Serial Number On A Savings Bond?
Maturity:
This is the agreed date when the bond must be repaid. Bonds are usually seen as low-risk products. The interest payments and maturity date are determined in advance so that the bond can become a stable and predictable source of income. The exceptions are when the bond is not held to maturity or if the issuing party goes bankrupt.
Who issues bonds?
Although there are several entities that can issue bonds, there is a general distinction between two types of issuers:
- Government bondsGovernments often use bonds as a way to generate money to finance the costs of roads, schools, bridges or other infrastructure. In some countries, even the cost of an (unforeseen) war can also mean the need for large sums of money. Bonds often have a maturity of ten years or longer and are considered long-term investments.
- Corporate bondsCorporate bonds are issued by companies to help them expand their operations. By issuing bonds, companies can buy real estate and equipment and carry out profitable projects. The extra income can also be used for research and development or to hire new staff. Companies may need more money than a regular bank can lend. Bonds can solve that problem by allowing many individual investors to lend money. Business loans can vary from being extremely safe to be very high risk.
Four different types of bonds
In addition to different issuers, there are also different types of bonds, depending on their characteristics. Four common types are:
- Perpetual bondsThese bonds do not have a fixed maturity date and may never be repaid.
- Convertible bonds under certain conditions can be converted into shares in the company.
- Interest rate adjustment loans these bonds have a variable interest rate.
- Subordinated bondsIf the issuing entity goes bankrupt, these bonds are repaid only after all other outstanding debts have been repaid. Because of that, the risks and returns are relatively high.
How to buy bonds
The most common way to buy bonds is through a broker. The commission for the purchase varies from broker to broker. At DEGIRO, you can buy government and corporate bonds online on a large number of exchanges. The transaction fee depends on the bond market. Unlike other financial instruments, bonds are not priced in currency but as a percentage of the nominal value. This makes it easier to calculate the effective interest rate.
What determines the price of a bond?
Bonds that you own can be traded. Despite the fact that the coupon rate and face value are constant, the value of the bond can still vary depending on several factors.
First, bonds are countercyclical, which can affect their value. When the stock market is doing well, bonds are often less sought after by investors because other financial instruments, such as stocks, seem more profitable. It causes the value of a bond to drop. In this case, issuing parties must promise higher interest payments for the bond to remain attractive to investors.
Another factor that determines the price of a bond is the interest rate policy. If a central bank keeps interest rates low and is expected to do so throughout the life of a bond, alternative investment options may be more attractive to investors. That can cause bondholders to sell the bond, which lowers the price. Generally speaking, the value of a bond moves in the opposite direction to the interest rate. For example, if interest rates rise, the value of the bond will decrease.
Potential risk also affects the price. When shareholders believe that risk is increasing, the price of a bond may fall. When risk increases, investors want higher compensation.
The length of time is another factor that determines the price of a bond. Bonds with longer durations, such as ten years, pay more than bonds with shorter durations, such as one year. The reason is that the lenders get paid for choosing to invest their money for a longer period of time. Long-term bonds normally have a higher coupon rate than short-term bonds. The time to maturity can also affect the value of a bond. Here, the closer the maturity date, the more the price approaches the nominal value.
The benefits of bonds
The most obvious advantage of a bond is that it is a relatively safe investment. If you hold it until the maturity date, the face value is returned, unless the entity has gone bankrupt.
Bonds can be profitable in two ways. First, if you own the bond until maturity, you get the face value. Before that date, you will receive interest payments (the coupon). Second, you can take advantage of an opportunity to sell your bond at a higher price than you bought it for.
Risks with bonds
Investing can be profitable, but it is not without risk. At DEGIRO, we are open and clear about the risks of investing. Before you start investing, there are a few factors that you need to consider. It helps to think about the level of risk you are willing to take and the type of products that best suit your goals. Although the maturity date of a bond is fixed in advance, there is always a possibility that the issuing party may go bankrupt. That is why bonds are often given a risk assessment by an independent credit ratings agency, such as Moody’s or Standard & Poors.
The information in this article has not been written as a recommendation, nor is it intended to suggest any investment. Keep in mind that facts may have changed since the date the article was originally written. Investing involves risk. You may lose (part of) your deposit. We recommend that you only invest in financial products where you are aware of the risks the investment may involve.
