Bond Basics

Bond Basics

Bonds, also known as bills, notes and debt obligations, are officially issued pieces of debt security similar to I.O.U.s issued by the government or a corporation. Purchasing a bond is effectively lending money to the government (through what they call an issuer), and then they will guarantee full repayment of the face value with a particular rate of interest attached to it. It is repaid after a specific due date or when it has reached its official age of maturity, which we will get to in just a moment.

Face Value

The face value of a bond is defined as the amount of money that a bond owner will receive once a bond matures. Its original price at the time of the initial purpose is known as the par value or principal. Corporate bonds will usually have a base amount of 1,000 dollars, but government bonds will often be much higher. This should not be confused with the price of a bond, which can either be sold for above or below the par value. When it is traded above the par value, then it is known as a premium, whereas a bond traded below it is known as a discount.

Coupons

When a person purchases a government or corporate bond, they will receive what is known as a coupon. The physical bond usually came with removable coupons that can be redeemed for interest, but this is no longer as common, and now most interest rate coupons are stored electronically. Bonds will often pay interest bi-annually, but there are many different payment options.

The coupon should be seen as a percentage of the face value. A 5% coupon for a 2,000 dollar bond, for example, will provide 100$ a year. This is just one example of a fixed-rate bond, but there are also adjustable interest payment plans, called a floating-rate bond. Unlike fixed-rate bonds, these floating-rate ones are defined by its shifting market value. Lower-percentage coupons are more favorable for investors though, because the fluctuation of its interest rates is more sporadic.

Maturity

A bond’s maturity is the specific future date that the investment must be repaid on. This amount of time can vary from one day to 30 years, but bonds that mature over a shorter amount of time are generally less risky. It is almost guaranteed that a long-term bond will fluctuate more than a short-term one.

Picture of a bond.

Issuer

One of the major things to consider when purchasing a loan is the issuer, as their credibility is crucial to you getting your investment back. This credibility factor is reserved exclusively to corporations, as the government is generally considered a risk-free asset. What you should consider is the default risk that you may be subject to. Corporations may not be able to pay back your loan for several unforeseeable reasons, and they are generally bound more by profits than by repayments. The government on the other hand, will always have an influx of money from taxation. For this reason alone, corporations must offer a higher yield on the bonds to get noticed by investors. This theoretical process is also known as the risk/return trade-off.

Because there is an uncertainty in trading with corporations, a bond rating system needs to be established. It is similar to an annual report card that rates the safety of investments based on the company. The best firms are known as blue-chip firms, while companies that are graded below a certain rating have what are called junk bonds. These junk bonds are extremely risky but draw a higher yield, but companies who are in the red see them as debt that need to be sold off.

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