What are bonds?

A bond is a financial product that allows an investor to lend money to an issuing entity. In return for owning a bond, lenders are paid interest, also called the coupon rate. Simply said, it is a form of borrowing. The buyer of a bond is by definition the lender, whereas the issuer is the borrower. Issuing bonds is a way in which entities can finance themselves. The money a company receives from issued bonds is seen as a loan. In general, it must be refunded overtime on a date that is agreed upon beforehand. Until that date, the bondholder (lender) receives interest payments. Issuing entities can be corporations, cities or even national governments.

What should you know about bonds?

There are three key elements of a bond that are important to understand: coupon, par value and maturity date.

Coupon:

The coupon (or coupon rate) is the interest rate that is paid by a bond’s issuer. For instance, a $1,000 bond with a 5% annual coupon will pay $50 a year. The word coupon originates from a time when bonds had a paper coupon attached to them, which could be converted for payment.

Par (face) value:

The par value is the nominal value of a bond. It is also commonly referred to as face value. This is the amount paid to the bondholder when it matures. If the interest rate rises higher than the coupon rate, then the bond will trade below par. When the rate falls below the coupon rate, it will trade at a premium, or above par.

Maturity date:

This is the agreed-upon date on which the bond has to be refunded. Bonds are typically seen as low-risk products. The interest payments and maturity dates are set in advance, allowing it to become a stable and predictable source of income. The exceptions to this are when the bond is not kept until maturity or when the issuing party declares bankruptcy.

Who issues bonds?

Although several entities that can issue bonds, there is a general distinction made between two types of issuers:

  • Government bonds

    Governments commonly use bonds to generate money to fund expenses such as roads, schools, bridges or other infrastructure. For certain countries, the expense of an (unpredicted) war may also demand the need to raise funds. Bonds often have maturities of ten years or longer and are considered to be long term investments.

  • Corporate bonds

    Corporate bonds are issued by companies to help them grow their businesses. By issuing these, companies can buy property and equipment and undertake profitable projects. The extra income may also be used for research and development or to hire employees. Companies may need more money than the average bank can provide. Bonds can solve this problem by allowing many individual investors to lend out money. Corporate debt can range from extremely safe to super risky.

Four different types of bonds

Aside from the various issuers, there are different types of bonds depending on their characteristics. Four common types are:

  • Perpetual bonds

    These bonds do not have a fixed end date and have the potential to never be repaid.

  • Convertible bonds

    Under certain conditions, these can be converted into shares of the company.

  • Floating rate note

    These bonds have a variable interest rate.

  • Subordinated bonds

    In case the issuing entity goes bankrupt, these bonds are repaid only after all the other outstanding ones are repaid. Because of this, the risks and returns are relatively high.

How to buy bonds

The most common way to buy bonds is through a broker. Commissions for the purchase vary from broker to broker. With DEGIRO, you can buy government and corporate bonds online on a large number of exchanges. The transaction fee depends on the bond market. In contrast to other financial instruments, bonds are not priced in currency but as a percentage of the par value. This makes it easier to calculate the effective interest rate.

What determines the price of a bond?

The price at which bonds are bought or sold can depend on several factors. Although the coupon rate and par value are constant, their value can still fluctuate. Here are the main factors that can influence the price of a bond:

Market conditions: Bonds are counter-cyclical, which can impact their value. When the stock market is doing well, bonds are often of less interest to investors because other financial instruments, such as stocks, seem more profitable. This causes the value of a bond to drop. In this case, issuing parties must promise higher interest payments to keep the bond attractive to invest in.

Rate policy: Most bonds pay a fixed coupon rate that becomes more attractive if interest rates decrease. This results in an increasing demand and drives up the price of the bond. On the contrary, if interest rates increase, the fixed coupon rate paid by a bond becomes less interesting for the investors, resulting in a decline in its price. Generally speaking, the value of a bond moves in the opposite direction as the interest rate. The concept is simplified in the image below:

impact of interest rate

Potential risk: When shareholders think that there is an increase in risk, the price of a bond can fall. As the risk increases, investors want more compensation.

Duration: Bonds with a longer duration, for example, ten years, pay more than those with a shorter duration, such as one year. The reason is that lenders are being paid for investing their money for a longer period. Long term bonds are likely to have a higher coupon rate than short term ones. Time until maturity can also influence the value of a bond. Here, the closer it gets to maturity, the more the price approaches face value.

Rating: Rating agencies (e.g. Moody's & Standard Poor's) assign credit ratings to bonds. These are essentially based on the security of the bond. As the credit rating declines, bonds’ price will most likely to decline as well, becoming less attractive to investors.

Investors who plan to hold the bond until the end don’t really need to worry about price movements in the market, since at the bond's maturity they will receive the entire initial capital invested (beside issuer default). Price movements, on the other hand, concern those who want to sell the bonds before their maturity.

The advantages of bonds

The most apparent advantage of a bond is the fact that it is a relatively safe investment. If you keep it until the maturity date, the par value will be returned unless the entity defaults.

Bonds can be profitable in two ways. First, if you own the bond until the maturity date, you will receive the par value. Before that date, you will receive interest payments (the coupon). Secondly, you can benefit by selling your bond at a higher price than you bought it.

Risks of bonds

Investing can be rewarding but it is not without risk. At DEGIRO, we are open and transparent about the risks that come with investing. Before you start to invest, there are several factors to consider. It helps to think about the risk level that you are willing to take and what type of products are best suited to reach your goals. Even though the maturity date of a bond is set beforehand, there is always a chance the issuing party can default. That is why bonds are often rewarded with a risk rating by independent credit rating agencies, such as Moody’s and Standard & Poors.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.

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Note:
Investing involves risks. You can lose (a part of) your invested funds. We advise you to only invest in financial products which match your knowledge and experience. This is not investment advice.

Investing involves risks.

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