A bond is a loan, a form of debt or IOU. However, in this case the customer, i.e. the person who acquires the bond, serves as the bank. If you purchase bonds you are lending money to the government, a city, or a company. The borrower promises to pay the bondholder back in full, sometimes with regular interest payments.
Just as people sometimes need to take out loans, large organizations, including corporations and governments, need to borrow money too.
One of the best ways for them to raise funds is through issuing bonds.
National and local governments may issue bonds because they need to raise funds for a large project, such as a new bridge, dam, or railway link. Many governments often find themselves short of money because they overspent or collected less in taxes than they thought they would, so they borrow by issuing bonds.
$1,000 Series EE savings bond featuring Benjamin Franklin. Interest ceases 30 years from issue date. (Image: Wikimedia)
Bonds started many centuries ago
The first general government bonds were issued by the city of Amsterdam in 1517. Annual interest rates at the time were around 20%.
In 1694, the Bank of England issued the first ever bond by a national government. England needed money to finance its war against France.
Many years later, European governments started issuing perpetual bonds (with no maturity date) to fund government spending and the many wars that ravaged the continent.
In the 20th century, the use of perpetual bonds ceased. Today, governments issue bonds with a limited term of maturity.
Specifically, bonds are fixed-income securities, meaning that the income they generate are predetermined, or ‘fixed’ at the time of sale. No matter what happens, whether the economy does well or badly, the borrower will have to pay this fixed amount to the lender.
The contract states when the loan must be repaid, as well as the interest rate the borrower (issuer) must pay the holder.
During the First World War, the British Government issued War Bonds.
Coupon Bonds and Zero-Coupon Bonds
1. Coupon Bonds: you buy a bond, the borrower (issuer of the bond) will pay you a fixed amount periodically, and then return your initial investment at the end of the term. A long time ago, bonds used to have coupons attached to them – pieces of paper with a date and money value. On the specified date the owner tore off the coupon and presented it to get payment.
2. Zero-Coupon Bonds: you buy a bond, the borrower does not have to make periodic payments, but will return a larger amount to you at the end of the term.
Companies typically issue coupon bonds while governments tend to issue zero-coupon bonds.
If you are considering purchasing bonds, you should look out for:
– the interest the bond pays (coupon rate),
– how often interest is paid (coupon period),
– the end of the bond term (maturity date), and
– how much is paid back at the end of the term (face value).
What are the different types of bonds?
There are four main types of bonds and they differ by who is selling them. For example, they can be sold by the US Government, corporations, local governments, and foreign governments.
Treasurys (issued by the US federal government) – treasurys are issued by the US Treasury Department, they are guaranteed by the US government. There are different types of treasurys (that differ on interest rates and length of maturity), these include: Treasury bills, Treasury bonds, and Treasury notes. (Nobody can explain why it is pluralized ‘treasurys’ and not ‘treasuries’).
Other US government agencies – other government agencies that issue bonds (apart from the US Treasury) include: the Government National Mortgage Association, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation.
Corporations – companies can issue bonds in the public securities market. Typically they have a higher interest rate than government bonds – as the risk of default is higher.
Local governments – an effective means of raising money for local governments, without having to increase tax rates, is issuing bonds.
Par value, coupon rate, maturity date
You need to understanding these terms in order to properly compare bonds and see which are best suited to you.
Par value – this is the the face value (or principle) of a bond – the sum of money the lender will receive when the bond has reached maturity – usually the par value of bonds are $1,000 or $100.
Coupon rate – this is the percentage rate of interest, typically paid twice a year.
Maturity date – this is the date when the issuer (borrower) has to pay the principal back to the lender.
Investing in bonds versus stocks
The general consensus is that investing in bonds is safer compared to investing your money in the stock market.
Bonds are less volatile than stocks. Governments and top corporations issuing the securities offer unparalleled security, and they can potentially generate higher interest payments than dividend payments.
However, it is important to understand that bonds are associated with a high degree of interest rate risk.
This occurs when interest rates fluctuate – directly affecting the price of the bond. For example, if market interest rates increase, then the price of the security will decrease.
Safe versus risky bonds
The safest bonds in the United States are those issued by the federal government. As mentioned above, these are the Treasurys – they are backed by the ‘full faith and credit’ of the US. They are the nearest one can get to a completely risk-free investment.
However, the higher security comes with a lower bond yield, compared to others. Bonds issued by a blue-chip company like Microsoft Inc. will give you a higher yield than Treasurys, but less that those issued by, say, Shifty John’s Betting Shops (‘junk bonds’).
What are junk bonds?
High-yield (non-investment grade) bonds are known colloquially as ‘junk bonds’. They are fixed-income instruments that carry a ‘Ba’ or below rating by Moody’s and ‘BB’ or below rating by Standard & Poor’s.
They are called junk bonds because there is a much higher risk of default (the issuer not being able to pay you back).
If you are interested in buying junk bonds, bear in mind that they are risky. However, many investors are attracted to them because they offer much greater yields than safe bonds.
If the issuer of junk bonds manages to thrive and achieves a better credit rating, those bonds will be in high demand and will fetch good prices.