What are Bonds?
Bonds are a form of investment where investors are able to loan their money to a company or entity where they borrow the funds for a monetary gain in the form of interest once the bond expires. This interest rate can be one of two things: fixed or variable (changing).
How Do Bonds Work?
A bond is a form of investment where investors are able to loan their money to a company or entity where they borrow the funds for a monetary gain in the form of interest once the bond expires. This interest rate can be one of two things: fixed or variable (changing).How Do Bonds Work?
Bonds are fixed-income security and one of the main asset classes next to stocks. When a company needs funds for their new projects, they offer bonds. Instead of going to a bank, they offer investors a chance to invest in the company in the form of a bond. As previously stated bonds can have a fixed or variable interest rates. When an investor purchases a bond they review a coupon that indicates its interest rate and this interest rate can change over time. This is typically a safer investment than stock due to it having less volatility, however, the reward cannot exponentially grow like a stock.
We will use an example for a bond with a fixed interest rate of 10% annually. If one was to take advantage of this and buy one bond for $1,000.00 with a return of 10%, the individual would not be able to take the funds out, however, when the bond matures they’ll be able to sell that coupon and get their initial investment back along with the accumulated interest ($100.00).
Due to the lack of volatility and the constant interest rate it, this investment is appealing to many investors. Of interest rates decline to 4%, the bond coupon would pay out a sum of 5% on the initial investment. However, if the interest rates rise to 6%, the bond would still pay out a total of 5% when it matures.
Characteristics of A Bond
Similar to stocks, bonds all have similar characteristics that make them a bond such as:
Face Value: This term refers to the amount that the bond will be worth once it matures. It can also be the amount that the company who issued the bond refers to when calculating interest payments. This can mean if someone pays $1,100.00 for a bond and another person pays $900.00, both parties will receive the same face value of $1,000.00 when receiving their interest payments.
Coupon Rate: The coupon rate is the interest rate that will be paid once the bond matures. For example, the bond is $1,000.00 at the interest rate of 10% per year, when the bond expires in one year there will be a return on investment of $100.00.
Maturity Date: The maturity date is the time in which the bond expires and the issuer will have to pay out a certain interest rate to the individual who purchased the bond.
Coupon Date: Coupon date are the days that the issuer will pay out to the investor interest owed, these dates are usually annually or semi-annually.
What Determines The Interest Rate?
The interest rate can be determined based on a few criteria: The length of the bond and credit rating of the issuer. If the issuer has a poor credit rating, their bonds may be bought at a discount. However, bonds that have a high default risk (junk bonds) are likely to have a higher interest rate. This is due to them being a higher risk investment.
Types Of Bonds
Zero-Coupon Bonds: These are securities that are not sold at the regular market price. They are sold at a discount and reach face value when they mature. This means that these types of bonds do not pay out any interest payment. However, the difference between the discounted price becoming face value is generally the same as the interest payouts.
Convertible Bonds: These options give an individual who holds the bond the ability to make a call option. This means when a stock reaches a level that’s acceptable to the investor, they can convert their debt into equity.
What Are They?
A discount bond is an investment that is being bought at less than face value. This is typically due to a fluctuation of interest rates. An example would be if the face value of a bond was $1,000.00, the bond would be sold at a discount for $950.00.
A bond would be sold at a discount to the issuer would not have to pay any interest payments. It is likely that if the interest rates were to increase this would lead to bonds being sold at a discount.
- Bond bought at $1,000.00 at 5% meaning that in a year the investor would get $50.00 a year or $25.00 semi-annually.
- Discount bond bought at $950.00, bond matures in a year paying out $1,000.00
This is appealing to both investors and issuers because it waives the responsibility of having to pay semi-annual interest payments. Also, the investor is able to sell their bond at face value even though it was purchased at a discount. However, this can be a riskier investment because bonds sold at a discount are not always a positive sign.
There are also opportunities to get what is called a distressed bond. These are bond that has a much higher chance of defaulting. However, with that risk comes a higher reward because these bonds are typically sold at a larger discount than usual. These bonds do not receive full or on-time interest payments due to the nature of the bond.
What Is It?
A put bond allows the bondholder the right to force the bond issuer to purchase their bond back. This is bought back at a date that is before the original maturity time. When doing this, the issuer is forced to repurchase the bond back at face value.
What’s The Point?
The is an actually a very good reason why investors would do this. One reason is that they purchased their bond at a specified fixed rate and now the interest rates are increasing. When rates increase, the current bond becomes less valuable because it would now hold an interest rate lower than the high-interest rate environment. Therefore, investors will force the company to buy their bond back at face value. The individual would then buy the bond with the new rates, this is also known as a bond swap. An investor cannot do this an unlimited amount of times, this is only a one-time benefit per bond.
Christopher is just a man on a mission to help those around him gain financial success. Obsessed with writing about all things finance, this GTA native is constantly learning and sharing his experiences with others.