What is a bond? Definition and meaning
A bond is a loan, a form of debt, or IOU. However, in this case, the person who acquires the bond serves as the bank. In other words, the customer is 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 the borrower pays the money back in full regular interest payments.
Just as people sometimes need to take out loans, large organizations need to borrow money too. Examples of large organizations are national governments, local governments, and big companies.
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. Perhaps they plan to build a new bridge, dam, or a railway link.
The US issues Treasury securities when it needs to borrow money, while the British government issues gilts. The term ‘gilt-edged securities’ refers to bonds that either the government or blue chip companies sell.
Many governments often find themselves short of money because they overspent. The government may have collected less in taxes than it had expected. Therefore it needs to borrow money. The government borrows money by issuing bonds.
Bond short history
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 to fund government spending. Additionally, they needed money to finance the many wars that ravaged the continent.
** Perpetual bonds have no maturity date.
In the 20th century, the use of perpetual bonds ceased. In fact, all governments today issue bonds with a maturity date.
Specifically, bonds are fixed-income securities. In other words, the issuers fix the income that they generate at the time of sale. No matter what happens, the borrower will have to pay that set amount to the lender. Even if there is an economic crisis, the issuer must make those payments.
In this article, the words ‘issuer’ and ‘borrower’ have the same meaning.
The contract on the bond states when the issuer has to pay back the money. It also states the interest rate that the issuer must pay the holder.
Coupon and Zero-Coupon Bond
With coupon bonds, the borrower pays you a fixed amount periodically. It then returns your initial investment at the end of the term.
A long time ago, the issuer used to attach coupons. These coupons were pieces of paper with a date and money value. On a certain date, the owner tore off the coupon and presented it to receive money.
With zero-coupon bonds, the borrower does not have to make periodic payments. However, the issuer will return a larger amount to you at the end of the term.
Companies typically issue coupon bonds, while governments prefer zero-coupon bonds.
If you are considering purchasing bonds, you should look out for:
- The coupon rate. In other words, the interest the bond pays.
- How often interest is paid. We call this the coupon period.
- The maturity date, i.e. the end of the bond term.
- The face value. In other words, how much the issuer pays back to you at the end of the term.
What are the different types of bonds?
There are four main types of bonds, and they differ according to who is selling them. For example, they can be sold by the US Government, corporations, local governments, and foreign governments.
Please note the spelling: treasurys. The US Treasury Department issues treasurys and the US Government guarantees them.
There are different types of treasurys. Their difference is determined by varying interest rates and dates of maturity. These include Treasury bills, Treasury bonds, and Treasury notes.
I-bonds, which the US Treasury issues, have two components: 1. A fixed interest rate. 2. A variable interest rate that adjusts every six months to the inflation rate.
Other US government agencies
Other government agencies that issue bonds include the Government National Mortgage Association and the Federal National Mortgage Association. The Federal Home Loan Mortgage Corporation also issues bonds.
Companies can also issue bonds in the public securities market. Typically, they have a higher interest rate than government bonds, because the risk of default is higher. Even though blue chip companies are extremely reliable borrowers, governments are even safer.
Bonds are an effective means of raising money for local governments. They are especially useful for local governments that do not want to raise taxes.
Par value, coupon rate, maturity date
You need to understand these terms to compare bonds properly.
- Par value – this is the face value. We also call it the principle. It is the sum of money the lender will receive when the bond has reached maturity. In most cases, the par value of bonds are $1,000 or $100.
- Coupon rate – this is the percentage rate of interest, which the issuer typically pays twice a year.
- Maturity date – this is the date when the issuer has to pay the principal back to the lender.
Bonds versus stocks
The consensus is that investing in bonds is safer than investing in shares. Bonds are not only less volatile than shares, but they are also safer. Governments are the world’s most reliable borrowers.
The companies that issue bonds are also the most reliable in the corporate world.
Furthermore, bonds have the potential to generate higher interest payments than dividend payments.
However, remember that with bonds there is 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 that the federal government issues. As mentioned above, these are the Treasurys. They have the backing of the ‘full faith and credit’ of the US Government. In fact, they are the nearest one can get to a completely risk-free investment.
However, higher security comes with a lower bond yield, compared to others. Blue-chip companies like Microsoft Inc. will give you a higher yield than Treasurys. However, Microsoft’s bond yield will be less than the yield on junk bonds.
What are junk bonds?
Junk bonds are high-yield, non-investment grade 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.
We call them junk bonds because there is a much higher risk of default.
If you are keen on buying junk bonds, bear in mind that they are risky. However, many investors like them because they offer much greater yields than safe bonds.
If the issuer of junk bonds thrives and achieves a better credit rating, those bonds will fetch good prices.
Yankee Bond – this is a bond that a foreign bank, foreign company, or foreign government issues. The borrower issues the bond US dollars.