A bond is a certificate issued by a government or corporation where the issuer agrees to pay the holder an agreed-upon amount with interest. Selling bonds is a common way for governments and businesses to raise capital.
Detailed Explanation:
A bond is a loan. It states who owes money and the repayment terms. The party that issued the bond pays the bondholder. Unlike stock, the bond owner does not own an equity interest in a company. Bonds are safer investments than stocks because bondholders are paid before stock owners in the event of financial hardship. A company could cut its dividends, but it cannot cut its interest payments to bondholders without going into default. But the potential for large returns is less because bondholders do not share a company’s profits.
Bonds are typically sold in increments of $100. Suppose in June 2023, an investor, Steve, purchases 100 15-year treasury bonds that mature in June 2038, and the bond has a coupon rate of 0.5%. Steve paid $10,000 for 100 bonds. The US Treasury must pay Steve $50 per year for 15 years. ($25 would be paid twice a year.) When the bond matures in 15 years, the US Treasury repays Steve the $10,000 the US government borrowed from him when he purchased the bonds, assuming Steve has not sold the bond.
Bonds are liquid and traded in the bond market. If Steve wants to sell his bond to Joan, he can, and then the Treasury’s payments are made to Joan.
Bond owners have two risks.
Credit risk – The issuer may default on the note, which means it cannot repay the bondholders. Treasury bonds are considered risk-free because the US government has never defaulted on a note. However, a company may declare bankruptcy because it is unable to pay its obligations. For example, owners of bonds issued by Lehman Brothers saw the value of their bonds fall to zero following the company’s bankruptcy.
Interest rate risk – When market interest rates increase, the value of a bond decreases. Using the above example, assume interest rates rise and the Treasury Department issues bonds paying 1%, or $100, on a $10,000 investment. Investors would be unwilling to pay Steve $10,000 for his bonds that pay only $50 annually when they could invest $10,000 in comparable bonds paying twice as much. Steve would have to drop his price to a point where the stream of $50 payments matches the 1% market interest rate. Inflation and a growing economy put upward pressure on interest rates which reduce the value of a bond. A drop in interest rates increases a bond’s price because the stream of payments becomes more valuable relative to other available investments.
For an explanation of interest rate risk, watch our video Bonds and Interest Rates. In the video, Christina decides to purchase a bond because it has a higher interest rate than the local bank’s certificate of deposit. Hard times force her to sell, but she learns a hard lesson when she cannot sell her bonds at the price she paid for them following an uptick in interest rates.
The bond market exceeds the stock market in the value traded. Investors classify bonds into four general categories:
Government Bonds – Bonds issued by governments. Governments issue bonds to secure the money needed to pay their bills. They are generally regarded as a safe investment because the national government of the issuing country backs them. Because of their low risk, they usually have a low coupon rate. However, during periods of hyperinflation and political instability, governments may be forced to pay very high rates on bonds. In September 2018, a bond issued by Argentina yielded 26.2%.
Corporate Bonds – Bonds issued by corporations. The investor is loaning the issuing company money. Generally, the credit risk is greater than government bonds because the investor is relying on the company’s ability to make payments.
Municipal Bonds – Bonds issued by states and local governments. State and local governments issue bonds to secure the money for local projects such as schools, airports, highways, or water and sewer treatment plants. General obligation bonds are municipal bonds that rely on a municipality’s revenue from all sources. A revenue bond depends on the income from the financed project to meet its debt obligations. For example, a school may be funded using a general obligation bond because the school does not generate any income. But a municipality may use a revenue bond to pay for a parking garage since it can charge users to park there. Municipal bonds typically pay less than other bonds because the interest is usually exempt from income tax.
Mortgage-Backed Securities – Mortgages are loans secured by real estate. Most residential loans are securitized, meaning they have been converted into a pool of mortgages that is then sold as a bond in the bond market. Mortgages are real estate loans. A single loan is not very liquid. A bank may have trouble converting the loan into cash. The terms of loans are known, but investors may not know anything about the borrower. Mortgage-backed securities are bonds with a pool of mortgages. They are sold on an exchange to create liquidity. Credit agencies rate the credit risk of bonds to give potential investors a better understanding of what they are purchasing. Most residential loans are securitized, meaning they have been converted into a pool of mortgages and are sold as bonds in the bond market.
Most investors do not have the time, resources, or ability to evaluate the credit risk of every investment. Investors rely on credit rating agencies to measure a bond’s credit risk. The rating agencies grade the issuer’s creditworthiness. Investors who want to take a minimal risk would invest in investment-grade bonds. The highest rating is AAA. Bonds with AAA to BBB ratings have a low probability of default. Investors willing to accept a higher risk in favor of higher yields may invest in junk bonds. The three most used rating agencies in the United States are Standard & Poor’s, Moody’s, and Fitch Ratings.
