What Is a Bond? Demystifying Bond Trading and Investing

Cookies and milk. Hansel and Gretel. Stocks and bonds. Some things just seem to go together. But as familiar as the phrase “stocks and bonds” might be, the truth is many investors are unsure what bonds are and how they work. This might cause some to shy away from bond investing.

Perhaps the intimidation stems from the fact that bonds are often referred to as fixed income or a “debt instrument,” two terms that average investors may not be familiar with. So, let’s describe bond investing with a more relatable and straightforward term—a loan from the bond investor to the issuer. That’s a simplified definition of bonds.

What Is a Bond?

Bonds are a type of fixed-income security in which an issuer (or borrower) is required to make periodic payments of a specific amount or rate at regular intervals.

Government entities, from the U.S. Treasury down to state and local municipalities, need to raise money—whether for specific projects or simply to fund basic services. Corporations often choose debt-to-finance acquisitions, upgrade plants or technology, and other things. So they issue bonds. Bonds are typically made up of three components:

• Principal. This is the face value of the bond, or the amount an investor initially pays to purchase it. The principal amount (also called “par” or “par value”) is typically set at either $100 or $1,000 per bond.
• Maturity. This is the date on which the money loaned—the principal—needs to be paid back. For example, a standard U.S. Treasury bond has a 30-year maturity.
• Interest rate. This is the annual amount, expressed as a percentage, the bond issuer must pay the purchaser over the life of the bond. The rate is also known as the “coupon” and is where the term “clipping coupons” came from. Even though the interest rate is expressed in annual terms, many bonds make coupon payments twice per year.

Reliable income is subject to the credit risk of the issuer of the bond. If an issuer defaults, no future income payments will be made.

Bonds tend to be viewed as a more stable and predictable form of investing compared to the stock market. Bonds may help you ride out the volatility the stock market tends to offer, no matter which direction the market might be headed.

Like stocks, bonds can run in cycles, but they’re typically less volatile. Bonds sometimes outperform stocks when a bear market hits, potentially providing a measure of diversification for investors who are attempting to put together more balanced portfolios. And like stocks, they do carry an element of risk, so investors should carefully research a bond and its risk before investing.

How Do Bonds Work?

Here’s a sample scenario to illustrate how a bond investment might work:

• Investor Anne buys a bond from XYZ corporation with principal (or face value) of $1,000, an interest rate (coupon) of 5%, and a maturity of 10 years.
• Each year, XYZ pays Anne $50, which is 5% of the $1,000 face value of the bond.
• After 10 years, Anne has collected a total of $500 in interest payments and XYZ buys the bond back from her at face value, or $1,000.

In this example, investor Anne has used the bond purchase to preserve capital—the initial $1,000 investment—while creating annual cash flow, the $50 yearly payments. That’s essentially how bonds work.

What Are Zero-Coupon Bonds?

Some bonds will return the principal at maturity but not make coupon payments along the way. To compensate the investor, these so-called “zero-coupon bonds” are typically sold at a discount to par value. So, for example, you might buy a $1,000 face value zero-coupon bond for $800, and at maturity, you’ll receive the $1,000 face value. Depending on the time to maturity, that discounted amount can be used to calculate an effective yield-to-maturity.

How Interest Rates Affect Bonds

But what if our hypothetical investor wanted to sell her bond before the maturity date? In that case, things can get a bit more complicated.

The interest rate of a bond at the time of issuance is affected by two factors: current interest rates and risk of issuer default. This rate is fixed for the life of the bond. Setting aside default risk for the moment, suppose investor Anne bought a 10-year maturity bond in a low-interest rate climate, but when she wanted to sell it five years later, interest rates had risen significantly.

In this case, investors could purchase newly issued bonds with higher rates than the one Anne is selling and thus earn a larger return on their principal. Because of this, Anne’s bond would trade at a discount, also known as “trading below par.” This discount allows a buyer of Anne’s bond to make a similar return on capital as if the buyer bought a newly issued bond with a higher interest rate. Remember: Regardless of where the bond is bought or sold, at maturity the bond owner will receive the par value of $1,000.

Here’s a highly simplified illustration of discounting:

Bond A: $1,000 bond issued five years ago with a 3% coupon would generate $30 per year in interest.

Bond B: $1,000 bond issued today with a 4% coupon would generate $40 per year in interest.

Bond A would need to be discounted to about $950 to make it competitive with current bonds ($30/$950 = 4%).

Once again, this is a highly simplified example of how interest rates can affect bond prices, but it illustrates the underlying concept. If the numbers were reversed and Bond B had a lower interest rate than Bond A, Bond A might be trading at a premium to its face value.

Risks Associated with Bonds

As mentioned, risk also plays a part in setting the coupon rate of a bond. Government bonds tend to be less risky than corporate bonds and thus will usually have a lower interest rate. But there can be different rates even among corporate bonds. This is because of something known as default risk.

Default risk is the estimated risk of an issuer going out of business and not being able to pay back the principal—and any remaining interest—on the bonds they’ve issued. The riskier the issuer, the higher the interest rate they’ll offer on their bonds. Governments and municipalities, as a general rule, rarely default on their bonds. However, there have been times when they’ve gone into temporary default.

Much of the risk in buying bonds can be mitigated by buying only those that are highly rated. Various agencies like Moody’s and Standard & Poor’s issue, track, and update bond ratings on a regular basis, but they each have their own grading criteria, so investors need to educate themselves on bond risks and ratings.

That being said, the bond market is fairly robust. Millions of bonds and other fixed-income securities are bought and sold every day in the secondary market (meaning after the initial issuance). That includes Treasury securities and corporate bonds of varying maturities. Bond traders and dealers provide liquidity to the bond market by posting bids and offers on bonds based on their relative yields and maturities, adjusted for the relative risk in each bond. It’s called bond arbitrage (or fixed-income arbitrage) and it’s part of what keeps bond prices in line.

Bottom Line on Bond Investing

Assuming there’s no default or other credit event, bonds can provide a steady income stream and act as a potential anchor of diversification in a portfolio. A portfolio that’s heavily weighted toward stocks might benefit from an allocation to bonds. But individual bonds can pose unique risks and thus may not be for all investors. Bond funds can spread the risk across many securities, but fund investing does come with its own set of risks, fees, and tax implications.

In other words, like with all investments, it’s important to do your homework before jumping in.

Investments in fixed-income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk, and special tax liabilities. May be worth less than the original cost upon redemption.