Bond is a financial instrument or a tradeable asset which can help companies or government gain capital. Bonds are in fact loan given by investors to their borrowers. In this case, investors are normally individuals and purchasing bonds give them an opportunity to take the role as a lender to lend a part of the capital needed.
Every bond has the following elements: face value (the amount of money investors can get on maturity date), coupon rate (interest rate), coupon dates (the dates that investors can get their interest), maturity date (the day that investors can get the face value), and issue price (the price that the bonds are originally sold).
The owners of the bonds are the creditors of the issuers who are oblige to pay back the principal by maturity day and pay the variable or fixed interest payments according to certain terms.
If we divide bonds according to the issuers, there are corporate bonds, municipal bonds, government bonds, and agency bonds. If we divide bonds according to their characteristic, there are zero-coupon bonds, convertible bonds, callable bonds, and puttable bonds.
How does bond work?
When companies or government need money for their new projects, they will issue bonds to asset to capital. Some bonds are traded publicly and some are traded privately, only between the borrowers and lenders. Later on, the initial holders will sell the bonds to other individual investors before the maturity date. On maturity day, bond holders will give the face value.
The face value of the bond is usually $100 or $1,000, but the issue price is based on several factors.
- Issuers’ credit quality
Issuers’ credit quality is graded by credit rating agencies like Standard and Poor’s and Moody’s. For the issuers that have high credit quality, they will be graded as investment grade, while the ones with poor credit quality are considered as junk bonds. The bonds with investment grade are normally sold at the higher price.
- The length of time
The length of time refers to the time from the day it is issued until it is expired. The longer it is, the higher risk it has, and the lower price it has.
- Coupon rate
Coupon rate is always compared with the market’s interest rate. If the coupon rate is lower than the market’s interest rate, the issue price will decrease; if the coupon rate is higher than market’s interest rate, the issue price will increase.
It is also common for the issuers to buy their bonds back due to the change of interest rate. If the interest rate decrease, the issuers can sell the bonds with a lower cost, thus they will choose to issue the bonds again.
Pros and cons of bonds
- Investors can gain interest income regularly.
- Investors can get face value back at maturity date.
- Investors can gain profit if they sell the bonds at a higher price.
- Bonds have a lower return compared with stocks.
- Issuers may default on payment.
- Bonds’ yield may decrease.