A bond is a certificate issued by a government or corporation where the issuer of the certificate agrees to pay the holder an agreed upon amount with interest. Selling bonds is a common way for governments and businesses to raise capital.
A bond is a loan. It states who owes money and the terms of repayment to the holder of the bond. Unlike stock, the owner of a bond does not own an equity interest in a company. Bonds are safer investments than stock because bond holders are paid before stock owners. But the potential for large returns is less because bond holders do not share a company’s profits.
Bonds are typically sold in increments of $100. Suppose in December 2020 an investor, Steve, purchases 100 15-year treasury bonds that mature in December 2035. The bond has coupon rate of 0.5%. This means Steve paid $10,000 for 100 bonds. The US Treasury is obligated to pay Steve $50 per year for 15 years. ($25 would be paid twice a year.) When the bond matures in 15 years, the US Treasury would repay Steve the $10,000 the US government borrowed from him when he purchased the bonds, assuming Steve has not sold the bond.
Bonds are liquid and traded in the bond market. If Steve wants to sell his bond to Joan, he can, and then the Treasury’s payments are made to Joan.
Bond owners have two risks.
Credit risk - The issuer may default on the note, which means it is not be able to repay the bond holders. Treasury bonds are considered risk-free because the US government has never defaulted on a note. However, a company may go bankrupt and be unable to pay its obligations. For example, owners of bonds issued by Lehman Brothers saw the value of their bonds fall to close to zero following the company’s bankruptcy. (However, bond holders did better than stockholders.)
Interest rate risk – When market interest rates increase, the value of bonds decrease. Using the above example, assume interest rates increase, and the Treasury Department issues bonds paying 1%, or $100 on a $10,000 investment. Investors would be unwilling to pay Steve $10,000 for his bonds that pay only $50 annually, when they could invest $10,000 in comparable bonds paying twice as much. Steve would have to drop his price to a point where the stream of $50 payments matches the 1% market interest rate. Inflation, and a growing economy put upward pressure on interest rates thereby reducing the value of a bond. A drop in interest rates increases the market value of a bond because the stream of payments becomes more valuable relative to other available investments.
For an explanation of bonds and the interest rate risk, watch our video Bonds and Interest Rates. In the video Christina decides to purchase a bond because it has a higher interest rate than the local bank’s certificate of deposit. Hard times force her to sell, but she learns a hard lesson when she is unable to sell her bonds at the price she paid for them following an uptick in interest rates.
The bond market exceeds the stock market in the value traded. There are thousands of bonds which can be classified into four general categories of bonds:
Government Bonds – Bonds issued by a national government to support government spending. Generally regarded as a safe investment because they are backed by the national government of the issuing country. Because of their low risk they normally have a low coupon rate. However, during periods of hyperinflation and political instability governments may be forced to pay very high rates on bonds. In September 2018, a bond issued by Argentina yielded 26.2%.
Corporate Bonds – Bonds issued by corporations. The investor is loaning the issuing company money. Generally, the credit risk is greater than government bonds because the investor is relying on the company’s ability to make payments.
Municipal Bonds – Bonds issued by states and local governments. The money is used to finance capital expenditures for local projects such as schools, airports, highways, or water and sewer treatment plants. Municipal bonds can be separated into general obligation bonds, which rely on a municipality’s revenue from all sources. A revenue bond relies on the revenue from the financed project to meet its debt obligations. For example, a school may be financed using a general obligation bond, because the school does not generate any income. A parking garage may be financed with a revenue bond since the municipality is able to charge users to park there. Municipal bonds normally pay less than other bonds because the interest is usually exempt from income tax.
Mortgage-Backed Securities - Loans secured by a bank are normally not very liquid unless they can be converted into a bond and sold in the bond market. Liquidity is created when an investor knows what he or she is purchasing and there is a market where it can be readily traded. The terms of loans are known, but investors may not know anything about the borrower. Credit agencies rate bonds to provide the investor with an understanding of the credit risk. Mortgages are loans secured by real estate. Most residential loans are securitized, meaning they have been converted into a pool of mortgages that is then sold as a bond in the bond market.
Most investors do not have the time, resources, or ability to evaluate the credit risk of every investment. Investors rely on credit rating agencies to measure a bond’s credit risk. The rating agencies grade the issuer’s creditworthiness. An investor that wants to take a minimal risk would invest in investment grade bonds. The highest rating is AAA. AAA to BBB have a low probability of default. Investors who are willing to accept a higher risk in favor of higher yields may invest in junk bonds. The three most used rating agencies in the United States are Standard & Poor’s, Moody’s, and Fitch Ratings.