What are Bonds and How do They Work?

Stocks often receive all of the attention when it comes to investing, but did you know that the total outstanding bond market is actually larger than the total market capitalization of outstanding stocks? Bonds are financial securities that can be bought, sold, and held in hopes of receiving modest to sizable returns. Bonds also serve the double function of reducing the overall volatility and risk profile of your portfolio. Considering bonds make up a substantial portion of the total outstanding securities, it’s worth understanding just what bonds are, how they work and how to invest in them.   

What is a bond?

Bonds are financial securities which allow investors to lend money to entities, typically corporations or governments in exchange for interest payments and principal repayment. Interest payments can be received throughout the term of the bond, but the principal is typically repaid at the end of the term of the bond.

Why do Companies Issue Bonds?

Companies typically issue bonds to investors in order to raise capital to support regular operations, refinance existing debt, the launch of a new project or because they have an acquisition target in mind. Governments issue bonds to fund new projects, manage cash flow, refinance existing debt or fund deficits. 

For companies, bonds offer substantial advantages over borrowing from a bank or issuing stock to raise capital:

  1. Advantages over borrowing from a bank: Bond issuances typically carry a lower interest rate for the issuer when compared to borrowing from a bank, meaning less cash outflow due to interest payments. While some bonds do have restrictive covenants, they are usually more relaxed than the terms that might be set if a corporation were to borrow from a single bank. 
  1. Advantages over issuing stock: The biggest reason why a corporation might choose to issue a bond over a stock is that issuing bonds doesn’t dilute ownership of the firm. Another big advantage over stocks is that interest on debt reduces taxable income for a firm and thereby reduces the amount of taxes the company would pay in any given year.

Pros and Cons of Bonds

Bonds make a solid investment for many, but any prudent investor should understand the upside and downside of bonds before executing a purchase. Depending on what you’re looking for in an asset class, bonds may be a perfect addition to your portfolio or something you should steer away from. 

Advantages of Bonds

Fixed returns: Bonds provide a steady stream of income through interest payments. This makes bonds a popular option for seniors living on a fixed budget who need predictable outcomes from their investments. It’s not just seniors that can benefit though, the periodic payments bonds provide make planning for the future a bit easier for anyone who relies on their investments for an income stream. Bonds are particularly attractive considering they typically bear higher interest rates than savings accounts.

Diversification: Another advantage of bonds is that they provide a way to diversify your investments by adding a less volatile asset class to your portfolio. While it’s wise to diversify within asset classes, it’s also a good idea to introduce different types of assets to your investment portfolio. The reason being that although it’s not too common, it is possible for an event to impact an entire asset class. Consider the uncertainty surrounding the stock market near the beginning of COVID-19.

Less risky: In the past, bonds have benefited from the flight-to-quality that occurs during financial downturns. When the market is shaky investors generally want out of risky asset classes and seek safe havens such as government bonds. Additionally, bond buyers are higher up in priority when compared to stockholders if a company is in financial distress and is forced to liquidate 

Disadvantages of Bonds

Capital requirements: The minimum amount of bonds you can purchase will depend on what kind of bond you’re planning to purchase. U.S. treasury bills can be purchased for as little as $100 However, municipal bonds are sold in increments of $5,000 and bonds for corporate companies typically start at $1,000 on the lower end.

Credit or Default Risk: There is always the possibility that a firm which issues bonds won’t be able to repay their debt obligation. If you’re concerned about this type of risk, consider sticking to bonds which are rated highly by credit rating agencies to minimize your risk. It’s worth noting that low rated bonds can be appealing to aggressive investors since they typically offer higher returns.

Liquidity risk: While bonds are generally regarded as liquid assets, it’s important to note that different bonds can have varying levels of liquidity. Some assets, such as U.S. government bonds, are highly liquid; however, bonds from companies in financial trouble could be less liquid since market appetite might be timid at best for these types of bonds. Aside from U.S government bonds, stocks are generally considered more liquid than bonds.  

Interest rate risk: The value of a bond can fluctuate based on the prevailing interest rate in the market, resulting in interest rate risk. As rates rise, the price of a bond will decline and as rates fall bond prices will rise. 

Example

Interest Rate Relationship With Price

Let’s say market interest rates are 4% and you’re offered a bond, which features a 4% return with a face value of $1,000. As an investor this appeals to you since the interest payments will be equal to what you could capture in the market. Now if the market interest rate were 5%, you would likely be willing to pay less than you originally would have since you’d be earning 1% less than the prevailing market rate. Similarly, if the market interest rate were 3%, you might be willing to pay a bit more to earn 4%. The aforementioned example illustrates why bond prices change when market interest rates move, which is known as duration.

Reinvestment risk: Since investors typically hold bonds for a couple of years, there is always the chance that interest rates will be low when the bond matures or is sold, meaning a lower yield on future investments.  

Key Characteristics of a Bond

Coupon: The coupon rate is the interest rate that will be paid to the investor and is typically expressed in percentage form. Coupons can be paid in varying frequencies, including annually and semi-annually. A 4% coupon on a $1,000 bond, which pays out interest annually, would result in a $40 interest payment every year. 

Face Value or Par Value: Face value and par value are interchangeable terms which refer to what the bond is worth at the time of issuance. The face value is also the amount of money that is due back to the investor once the bond reaches its maturity date. Most corporate bonds have a face value of $1,000 while municipal bonds are sold in increments of $5,000. 

Price: The price refers to the amount that the bond would command in an active market if the holder of the bond were to sell the security. 

Yield: The bond yield refers to the return an investor receives from a bond. Since investors can purchase bonds at varying prices, the yield can differ from the coupon. However, if a bond is purchased at par, it is possible for a bond yield to be equal to the coupon.

Maturity: The maturity date is established when the bond is created and refers to the date when the investor will receive back the face value of the bond. 

How Do Bonds Work?

Due to the nomenclature surrounding bonds, they can be an intimidating financial security to understand. However, the transactions between an investor and an issuer that take place when a bond is issued are actually quite simple. Below, we lay out a fictional debt issuance to help you better understand how bonds work. 

To understand how bonds work let’s consider a fictional company, named BetterBuy, which is a public medium-sized electronic retailer operating in North America. The company has done well in growing its business and now operates 300 stores in the United States and Canada. BetterBuy faces fierce competition in the North American region, but sees opportunity for growth in the European market. 

The company runs a few analyses and determines that it needs $40 million to open a few locations overseas, establish a European headquarters, hire personnel, and launch an aggressive marketing campaign. The company’s executive team decides to raise the capital by issuing bonds since the founders retain a large share of the existing stock and are reluctant to give away additional equity. 

BetterBuy issues $40 million worth of 10-year bonds, each separate bond consisting of a $1,000 par value and a 4% interest rate, meaning a total of 40,000 bonds are issued ($40 million divided by $1,000). The bonds will pay investors their original $1,000 back at the end of the 10 year term along with interest of 4% on an annual basis.  

BondBuyers is an investment firm seeking to increase their exposure to the North American electronic retailing space, so they buy some of BetterBuy’s bonds. For each bond that BondBuyers buys, they will receive $40 per year in interest payments (4% multiplied by $1,000) and at the end of the 10-year bond term they will also receive back the par value of $1,000.

Fast forward 10 years and BetterBuy’s European expansion has been a tremendous success. The company finishes paying off their bond debt (both interest payments and principal repayment). The bonds they issued 10 years ago have now been paid off and the financial instrument ceases to exist, meaning BetterBuy is free of any future obligation to investors, such as BondBuyers. 

What Types of Bonds are There?

There are four distinct categories of bonds investors can purchase:

Corporate Bonds: These bonds are issued by public and private companies and the interest earned from these bonds are taxable at the state and the federal level. These bonds typically yield a higher return than U.S. treasuries because they also tend to be a bit riskier. Bonds with high credit ratings are typically referred to as investment-grade bonds while those with low credit ratings are referred to as high-yield

Municipal Bonds: These bonds are issued by cities, states, counties and states. There are many popular types of municipal bonds, but the most common are general obligation bonds, revenue bonds and conduit bonds. General obligation bonds are backed by the issuer, which has the power to tax its residents. Revenue bonds, appropriately named, are backed by revenues from the specific project they were taken out to finance. Conduit bonds are created when a government issues out a bond on behalf of another institution such as a university or an art museum.

U.S. Treasuries: These bonds are issued by the Department of the Treasury and are generally regarded as one of the safest investments since they carry the full faith and credit of the US. government. The Department of Treasury offers several varieties of debt including treasury bills, treasury notes, treasury bonds and treasury inflation-protected securities (TIPS).

  • Treasury bills have a maturity date of one year or less. Bills don’t pay interest, but rather are offered at a discounted rate compared to the face value. For example, you may pay $950 for a bill and receive $1,000 at maturity.
  • Treasury notes have maturities between two and ten years.
  • Treasury bonds have maturities exceeding 10 years and typically mature in 30 years, paying interest twice per year.
  • TIPS are notes and bonds which pay interest twice per year and are issued with varying maturity lengths (5, 10 and 30 years). The principal of these notes and bonds is adjusted based on changes with the Consumer Price Index (CPI). 

Agency Bonds: These bonds are issued by agencies of the U.S. government and are most commonly issued by housing-related agencies. Agency bonds carry greater risk than U.S. treasuries since these bonds are not guaranteed by the U.S. government.  

Different Varieties of Bonds

Bonds are financial instruments, meaning that they can be modified to achieve any goal the issuer may have. Due to this, bonds can come in many different varieties. Below, we lay out the most common varieties of bonds.

Bonds with a call feature: A callable bond allows the issuing entity to pay off their debt before the official maturity date by exercising a call option on the bonds. The issuer is typically allowed to pay off specific maturities of bonds or the entire amount. A reason an issuer might activate a call feature is if interest rates have fallen below the rate they pay on the callable bonds. In this instance, it’s in the issuing entity’s best interest to refinance the bonds to save on interest. This is similar to why homeowners refinance their mortgage when rates are low.

Pro Tip: Callable Bonds
From an investor’s standpoint, callable bonds represent an opportunity to earn a higher return since issuers have to compensate market participants for the risk of the call being executed in the form of higher yields.   

Bonds with a put feature: Puttable bonds allow investors to demand the repayment of a bond before the bond’s stated maturity date. Investors might exercise a put option when interest rates are higher than the yield being earned on the bonds since the money could be reinvested at a higher rate. Additionally, bondholders may exercise put options if they have a lack of faith in the issuing entity’s financial future. Put bonds reduce the risk investors face when selling their bonds since they are guaranteed to receive the stated face value of the bond. Due to this, yields on puttable bonds are generally lower than their generic counterpart. 

Zero-coupon bonds: These types of bonds don’t pay any interest to investors as their name implies. Zero-coupon bonds are purchased at a discount and pay investors their states face value at the time of maturity. For example, an investor might purchase a zero-coupon bond for $900 and receive $1,000 at the bond’s maturity date. 

Convertible bonds: These types of bonds offer investors interest payments and can be converted to a predetermined number of shares of the issuing company’s stock. Convertible bonds can typically only be exchanged for common stock on predetermined dates, referred to as conversion dates, if the bondholder wishes to execute on the conversion. Convertible bonds allow investors to ease their concerns of default risk while reaping the benefits of success by converting a bond to common stock.

How are bonds issued?  

When issuing a bond, the issuing entity typically works with an investment bank or a financial advisor to understand their current debt portfolio and what their debt portfolio might look like after the proposed issuance. During this stage the investment bank or financial advisor can use recent transactions to gauge how receptive the current market might be to certain maturities at specific interest rates. 

Once the issuer and the bank agree on a general structure bond structure, a credit rating agency is typically contacted in order to perform a credit analysis on the bonds. The credit rating helps build trust with investors. A great credit rating can result in a reduced borrowing rate while a bad credit rating can cause yields to rise.

The last step in the process is the bond’s pricing day, where bond maturities are sold to investors in real time. Depending on investor appetite, the yields and general structure that the issuer initially intended on having in place can be locked in or differ significantly.

Trading Bonds Versus Holding Bonds

Whether you trade or hold a bond through maturity will dictate the return you receive when you purchase a bond. When you hold a bond through maturity you know exactly how much money you’ll receive in the future, which is the sum of future coupon payments along with the face value of the bond.

If you trade a bond before maturity, the return you’ll receive will depend on the changes in interest rates. Keep in mind that rates will in all likelihood change between the time you purchase a bond and the time you choose to sell said bond. If rates fall, the price on your bond goes up and if rates go up then the price on your bond will go down. Investors should note that some bonds are more sensitive to interest rate changes than others.

Pro Tip: Zero Coupon Bonds
Zero coupon bonds are highly sensitive to interest rate changes since they have a 0% coupon (no coupon).

The sensitivity of a bond’s price to changes in market interest rates can be measured by a quantity, which is referred to as duration. Generally speaking, a bond’s price sensitivity to interest rates is higher when:

  • There is a smaller coupon, or
  • The maturity date is longer

Intuitively, the faster you receive coupon and principal payments, the less sensitive to interest rates bonds are. That is because the price of a bond is simply the sum of future coupon payments along with the face value of a bond discounted using today’s interest rates. Therefore, more payments sooner means less discounting, which results in a higher price.