How Bonds Work
How Bonds Work
What are Bonds?
A bond is a fixed-income instrument that is essentially a loan between a lender and a borrower. The borrower pays the lender interest payments in exchange for borrowing money. This is how bonds provide investors with a fixed stream of income over a specified period. The bond market in the U.S. is the largest debt market in the world, offering numerous investment opportunities. These bonds include debt securities issued by governments, municipalities, and corporations whenever they need to borrow money. Investors typically receive income payments twice a year, in addition to the return of the principal value of the loan when the bond matures.
Bond Yields: The yield quoted to an investor who buys a bond is often different from the interest it pays. Why? Because in addition to the annual interest rate, the bond’s return reflects any difference between its purchase price and its face value—the amount that is expected to be received when the bond matures.
- If a bond is purchased at a price higher than the face value (at a premium), the investor receives less than they paid when the bond matures.
- If the bond is purchased at a price lower than the face value (at a discount), the investor receives more than they paid when the bond matures.
- If the bond is sold before it matures, the investor receives the current price, which may be higher or lower than the amount originally paid.
A bond’s yield is dependent upon several factors, including credit risk, time to maturity, and the bond’s coupon.
Credit Risk: Every bond carries some risk that the issuer will not make full and timely payments. This is called “default” risk, which is generally reflected in a bond’s yield. Rating agencies provide opinions on this risk in the form of a credit rating. Bonds with lower credit ratings generally pay higher yields because investors expect extra compensation for greater risk.
Maturity: Generally, the longer the maturity, the higher the yield. Investors expect to earn more from long-term investments because their money is committed for a longer period.
Coupon: This is the interest rate paid by the bond. In most cases, it will not change after the bond is issued.
Here are a few other important bond terms:
Duration: This is the term used to estimate how sensitive a particular bond’s price is to interest rate movements. Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid. Duration is measured in years and the longer the duration the more sensitive a bond’s price is to interest rate movements.
Face value: This is the amount the bond is worth when it is issued, also known as “par” value. Most bonds have a face value of $1,000.
Price: This is the amount the bond would currently cost if sold on the secondary market. Several factors play into a bond’s current price, but one of the biggest is how favorable its coupon is compared with other similar bonds and when the bond matures.
Callability: Some bonds have call provisions that allow the issuer to redeem the bond before maturity, typically when interest rates decline. If a bond is called, the issuer repays the principal to bondholders and stops making coupon payments. Call provisions can affect the expected return of a bond and should be considered by investors.
If you buy a bond, you can decide to collect the interest payments while waiting for the bond to reach “maturity” (the date the issuer has agreed to pay back the bond’s face value). However, you can also buy and sell bonds on the secondary market. After bonds are initially issued, their value will fluctuate based on changes in market conditions. If you plan to hold the bond to maturity, the fluctuations will not matter—your interest payments and face value will not change. But if you buy and sell bonds before maturity, you will need to keep in mind that the price you will pay or receive is no longer the face value of the bond. Not all bonds trade every day, so understanding a bond’s liquidity and sensitivity to changes in value is an important consideration.
Investing in fixed income can provide a predictable income stream and be an important diversifier in an investment portfolio. However, as with all types of investing, it is imperative to understand the risks before investing in bonds.
Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Capital Management, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.
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