Bond definition

Bond definition

What is a Bond?

Put simply, bonds are debt obligations. Entities that need money sell bonds and the money they receive in return is a loan. This loan builds up interest over time, which must be paid back to the buyers of the bond. It is conducive to think of buyers of bonds as lenders. Bonds are most commonly used to generate money by businesses and governments. They are often seen as reliable and referred to as fixed-income securities because the bond issuer and buyer can anticipate exactly how much money will change hands.

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Finance Bond Yield Definition

The yield or coupon of a bond is the amount of interest that is generated from it. These terms originate from a time when bonds were issued as physical, paper documents and investors would redeem actual coupons to access their interest fees. Usually, interest on a bond is paid semi-annually, but some are paid annually or quarterly, depending on the bond and issuer.

A bonds yield can be fixed or variable but depends on several factors. These include the amount which inflation is expected to rise by during the repayment period and the likelihood of being repaid in full. Many bonds are never paid back in full. This can happen if the bond issuer is financially unstable or if the bond buyer sells their bond in the open market before it matures.

If it is quite likely that the bond issuer will not keep up their repayments, the bond buyer will want to get as much money back in the short term as they can and will do this by raising the bonds interest rate. Bonds that are paid back over a longer period of time are also likely to have higher interest rates, as it will be longer before the bond buyer gets their money back.

Key Terms

Lets take a look at some other key terms associated with bonds:

Maturity date: This is the date by which the bond issuer must have finished repaying the loan in full. The maturity of a bond is usually between one and five years, but others can last from a few months all the way up to 30 years.

Century bond: This is a bond that will mature in 100 years time.

Face or par value: This is the full value of the bond. It indicates the total amount of money that is paid by the bond buyer by the maturity date. The face or par value is different from the price of a bond in the market, which fluctuates over time. The most common face value of a bond is $1,000. However, government bonds often carry face values as high as $100,000 or $1 million.

Premium: If a bond is sold for more than its face value it is said to be trading at a premium. In the secondary bond market, bond traders are often prepared to pay more than the face value of the bond if the value of its interest payments are greater than in other investment opportunities.

Ask price: Bonds are sold with reference to ask and bid prices. The ask price is, of course, the price a bond issuer asks to be paid for a bond.

Bid price: This is the highest price a trader will pay for a bond.

Zero-coupon bonds: This type of bond does not incur interest, but instead is sold for a discounted price to compensate. Despite not receiving any interest payments, the bond buyer will still profit because they will own a bond that is worth more than they have paid for it.

Secured/unsecured bond: Repayment is not guaranteed in an unsecured bond, but in a secured bond, assets belonging to the bond issuer are pledged to bond buyers, so if the bond issuer goes into liquidation or cannot pay back the loan, the bond buyer receives the loan value in assets.

Bond Advantages and Disadvantages

Advantages

  • They are seen as fairly stable investments as the total amount to be paid can be calculated from the start of the transaction.
  • Bond buyers can profit by selling their bond before its maturity date at a premium, i.e. for a higher price than they bought it for.
  • Bond buyers can reduce their risk of not being paid back in full by using bond mutual funds. These are pools of bond opportunities that are selected by expert fund managers. By investing in a range of bonds, the effect of one entity failing to make its repayments is lessened by the positive effect of the other investments.

Disadvantages

  • Bond issuers could fail to keep up repayments on the loan. Agencies such as Moodys and Standard & Poors (S&P) provide a rating system which gives investors a sense of a bond issuers reliability and likelihood to default on payments. Bond buyers should check the bond issuers rating before deciding to buy a bond from them.
  • If bond buyers opt to trade their bond before its maturity date, they could sell it for less than the price they bought it for, as bond prices fluctuate over time. As bonds approach their maturity date, however, their market value and face value tend to align.
  • Bonds provide a lower return on investment than stocks in the long-term. It is possible that a bond buyer would not earn enough in interest to cover inflation.
  • The world of bonds can be very confusing. Bond yields move inversely to the face values of bonds because as the demand for bonds increases, the yields decrease. However, many investors still choose bonds over stocks because they are a much safer investment. As stocks represent equity in a business, their price can rise or fall dramatically depending on the success of the business. On the other hand, the value of bonds is determined by interest rates and so are much more consistent.
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