A bond has two similar meanings:
- in financial terms, it is a kind of investment.
- in legal terms, it is money or property paid into court as security, such as guaranteeing the return of a defendant to court
A bond is essentially a promise or "IOU" by a borrower to pay fixed amounts to the holder of the bond on specified dates.
Often, bonds are issued by corporations or governments. The issuer offers them for sale at a specified amount (the face value,) often $1000. The issuer promises to pay that amount back on a specific date (the maturity), and to make regular, specified interest payments—often four times a year (quarterly)—in the meantime.
For example, someone who buys a $1000 bond in December, 2007, with a five year maturity and a "coupon interest" of 6% per year
- —pays $1000 to buy the bond in December, 2007
- —receives interest payments of $15 in March, June, September, and December of 2008, 2009, 2010, 2011, and 2012
- —receives the $1000 back in December of 2012,
for a total of $1300.
As recently as fifty years ago, bonds were issued in the form of paper certificates, which included a coupon for each interest payment. The bondholder actually needed to clip off each coupon with scissors and mail it to the bond issuer in order to receive each interest payment. For retirees fortunate enough to be living on the interest from bonds, clipping coupons was a regular and time-consuming task.
Bonds are one of the three main asset categories, the other two being stocks and cash. Compared to stocks, bonds offer less risk, but also less possibility of a large reward. A stockholder participates in the ups and downs of the business. When business is good the market price of a stock climbs; sometimes it skyrockets. When it is bad, it falls; sometimes, to a fraction of its former value. A stockholder who buys a stock, planning to sell it exactly five years in the future, can only guess as to how many dollars he will make or lose. A bondholder, in the example above, knows that if he holds the bond to maturity, he will have made exactly $300, and knows the exact day on which every payment will be paid and its exact amount... unless the issuer of the bond fails to keep the promise (defaults) on the loan.
Bonds represent debts which the issuer owes and must pay... unless the company is in such bad shape that it cannot meet its debts, usually meaning it is in bankruptcy. In the U. S., two big firms research the financial condition of bond issuers, grading bonds with A's, B's, and C's, almost like school grades. Personal investors usually buy "investment grade bonds." The grading companies judge that a default on these bonds is extremely unlikely.
Since bonds promise to pay a known number of dollars at known dates, and since investment grade bonds almost always keep that promise, they are considered to be a low risk investment.
Why is there any risk at all? The risk arises because bond's principal is locked up until the maturity date. Suppose the purchaser of the bond in the example above discovers in 2010 that he desperately needs his $1000 back, and can't wait until the bond matures in 2012. The bondholder can't actually get his money out, but what he can do is to sell the bond to someone else. This is easy to do, because just like the stock market, there is a bond market and it is highly liquid: willing buyers are always available. In practice, an ordinary investor just calls his brokerage and says "Please sell thus-and-such bond at the market price." But the market price is uncertain, and depends on the prevailing interest rate, and this is where the risk comes in.
To see why this is so, consider the bond example above. Suppose that after three years the bondholder wishes to sell the bond to somebody else. How much is the bond worth? Unlike stocks, there is very little judgement or guesswork involved, just a financial calculation based on the numbers. The bondholder who buys the bond in, say, December of 2010 knows that the bond is going to pay him
- —interest payments of $15 in March, June, September, and December of 2011 and 2012
- —$1000 when the bond matures in December of 2012.
How much should he pay for the bond? This is a standard financial calculation called the net present value of an income stream. Most spreadsheet programs provide a function for calculating it. It turns out that the calculation depends on one more variable: the interest rate. This bond has a coupon interest rate of 6%. If the prevailing interest rate is 6%, it turns out that the value of the bond is exactly its face value: $1000. In theory, a buyer should be willing to pay $1000 for the bond..
But if the interest rate is lower than 6%, the bond is worth more than $1000. For example, if the interest rate were zero... if the buyer was just as happy to get $1000 two years from now as to get it today... then the value of the bond would be just the total value of all of the future payments, or $1120. On the other hand, if the prevailing interest rate is higher than 6%, the value of the bond is less than its face value. For example, suppose the interest rate has risen to 12%, a rather large change. Why would a buyer pay $1000 to receive interest payments of $15 every quarter when he could buy a newly-issued 12% bond and receive interest payments of $30? The net present value calculation shows that the value of the bond is only $894.70.
So, someone who buys the example bond and sells it before maturity could find that it was worth anywhere from about $900 to $1100.
Most personal investors will own bonds in bond-based mutual funds that hold hundreds of bonds, all maturing at different times. Since most of the bonds are not at their maturity, their market value is affected by changes in interest rates. A sharp rise in interest rates can even cause the value of the fund to drop for a while. Nevertheless, over time, as the bonds in the fund keep paying their interest payments and paying off their principal, the value of the fund tends to rise inexorably at about the average interest rate of the bonds it holds.
- The firms are Moody's and Standard and Poor's. Each company has a rather complicated grading system. Moody's uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C; S&P's equivalents are AAA, AA, A, BBB, BB, B, CCC, CC, C and adds D for bonds that are actually in default. Grades of Baa/BBB or better are considered "investment grade."
- In reality, markets being what they are, the buyer won't be willing to pay quite that much, and the brokerage will definitely want a commission on the trade.
- Obviously, a bondholder who notices that interest rates have dropped and that their bond is worth more than its face value might well decide to sell it and take the profit.