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What is a bond?

Ever wondered how a bond works? Find out here.
By: Vivian Xia
Banking
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If you are familiar with finance and investments, you may have heard of the term “bond” and wondered what it was. A bond is a unit of corporate debt, usually issued by a government or corporation, to borrow money. As a result, many individual investors can assume the role of a lender, and the investors can in turn sell their bonds to others or buy bonds from others. Bonds traditionally pay a fixed interest rate to debtholders, though variable or floating interest rates are now common.

When a bond is issued, it includes the terms of the loan, interest payments that will be made and the time at which the loaned funds must be repaid. Bonds all have the following characteristics:

  • Face value- the amount of money the bond will be worth at maturity
  • Coupon rate- the interest rate the bond issuer pays on the face value of the bond
  • Coupon dates- the dates on which the bond issues will make interest payments
  • Maturity date- the date on which the bond issuer will have to pay the bondholder the face value of the bond
  • Issue price- the original price of the bond

Bondholders do not have to hold a bond all the way through to maturity, however, and they can repurchase and reissue new bonds.

Premium vs. discount bonds

Bonds all start as standard bonds, but they become a premium or discount bond once it starts trading on the market. A premium bond is a bond that is trading above its issue price, or par value, in the secondary market. This happens when the bond offers a higher coupon rate than the current interest rates offered for new bonds. Therefore, investors are paying more to get higher payoffs from interest.

A discount bond, on the other hand, is a bond trading for less than its par value in the secondary market. A bond will trade at a discount when it has a coupon rate lower than the prevailing interest rates on new bonds. As a result, investors are paying less to compensate for a lower coupon rate and therefore lower payoffs from interest.

Categories of bonds

There are four different categories of bonds offered on the market:

  • Corporate bonds- issued by companies, as bond markets offer more favorable terms and interest rates
  • Municipal bonds- issued by states and municipalities
  • Government bonds- issued by the government; a good example is those issued by the U.S. Treasury. These are also known as “treasuries” and are divided into bills, notes and bonds depending on the maturity date. Government bonds issued by national governments are also known as sovereign debt
  • Agency bonds- issued by government-affiliated organizations such as Fannie Mae or Freddie Mac

In addition to these kinds of bonds, you may also encounter foreign bonds, issued by a foreign entity, on some platforms.

Varieties of bonds

There are also different varieties of bonds, separated by rate or type of coupon payment, being recalled by the issuer, etc.:

  • Zero-coupon bonds- do not pay coupon payments, but instead are issued at a discount that will generate a return when the bondholder is paid the face value at maturity
  • Convertible bonds- allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions such as share price
  • Callable bonds- also has an embedded option but can be “called” back by the company before it matures for the principal amount
  • Puttable bond- allows bondholders to put or sell the bond back to the company before it matures, opposite of a callable bond

What happens when a bond defaults?

A bond default can occur when the bond issuer fails to make a payment within the agreed-upon period of time. It can happen when the issuer does not have enough money to make their interest or principal payment, and defaulting is often seen as a last resort because it severely restricts the issuer from qualifying for financing in the future. In the case of companies, they usually default when their revenues have declined to the point where they can’t make their scheduled payments. Meanwhile, the company will usually file for bankruptcy protection prior to defaulting to avoid being forced into bankruptcy.

When a bond defaults, it doesn’t just disappear. The bondholder is usually able to recover some of the original principal after the issuer liquidates its assets and uses that money to pay back its creditors. The bond will also continue to trade at reduced prices. Most investors won’t buy this debt, but some “distressed debt” investors will try to recover more money than the current price of the bond.

To avoid defaults, you should stick with high-quality individual securities or lower-risk bond funds, while active fund managers can do their research before buying bonds.

Conclusion

Bonds are essentially debt you buy from other entities, usually governments or corporations, that pay back interest over time. There are many types and varieties of bonds, along with premium and discount bonds. Bonds can also default when the issuer fails to make a payment during a specified period of time. When a company defaults on a bond, it is usually because its revenue has deteriorated to the point where they can’t afford to pay the money back. Following a default, the bond will continue to trade but at a much lower price, and the issuer liquidates its assets and redistributes the money to everyone they owe in an attempt to recover the bond. You should go with high-quality individual securities and lower-risk bond funds to minimize the risk of a default, and if you are an active fund manager, you should do your research before investing in a bond.

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