Bond
Quick Answer
A bond is a debt security through which an investor lends money to a government, company or other issuer. In return, the issuer agrees to repay the bond’s principal according to its terms and may also make interest payments. Bonds usually have a stated maturity date, although their structures and payment terms can vary.
How does a Bond work?
When an organisation needs to raise capital, it can issue bonds to investors.
The bond establishes a borrowing relationship:
Issuer = Borrower
Bondholder = Lender
A typical bond specifies:
a face value, also called par value;
a maturity date;
an interest or coupon rate;
a schedule for interest payments;
other contractual terms.
FINRA describes bonds as debt securities in which an issuer raises capital from investors and agrees to pay interest according to the bond's terms. At maturity, the issuer generally repays the bond's face or par value.
Some bonds pay a fixed coupon, while others may have floating or different payment structures.
Key features of Bonds
Several concepts are important when understanding bonds:
Face value: The amount the issuer generally repays at maturity.
Coupon rate: The stated interest rate used to determine scheduled coupon payments.
Maturity: The date when the principal is normally due to be repaid.
Issuer: Bonds can be issued by governments, companies, agencies and other organisations.
Market price: After issuance, many bonds can trade above or below their face value.
Yield: A measure of the return associated with the bond's price and cash flows.
Credit risk: The issuer may fail to make required payments.
Interest-rate risk: Bond prices can change when market interest rates change.
FINRA notes that bond prices generally fluctuate in the secondary market and that bond prices tend to fall when interest rates rise, and vice versa.
Simple Bond example
Suppose a company issues a bond with:
Face value: $1,000
Coupon rate: 5% per year
Maturity: 5 years
The annual coupon would be:
$1,000 × 5% = $50
If the bond pays interest twice per year, each payment would be:
$50 ÷ 2 = $25
If the investor holds the bond until maturity and the issuer meets all of its obligations, the investor would normally receive the scheduled interest payments and the $1,000 face value at maturity.
However, if the investor sells the bond before maturity, its market price could be above or below $1,000.
This example is illustrative only and does not represent an actual FxGrow product, bond or expected return.
Potential benefits and uses
Bonds can serve several purposes within financial markets.
They may be used to:
raise capital for governments or companies;
generate scheduled interest income;
diversify a portfolio;
manage different maturity and income requirements;
gain exposure to government or corporate credit;
compare market expectations through bond yields.
Different bonds can have very different risk characteristics. Government bonds issued by highly creditworthy governments may behave differently from lower-rated corporate debt.
Bonds can also be traded after issuance. FINRA notes that bonds may be purchased in the primary market and, for many securities, subsequently bought and sold in the secondary market.
Risks, limitations and common misconceptions
A common misconception is that bonds always return their full purchase price.
They do not.
If a bond is purchased for more than its face value, held only briefly or sold before maturity, the investor's realised result can differ significantly from the face value.
Bond investors may face:
credit risk: the issuer may fail to meet its obligations;
interest-rate risk: rising market rates can reduce the market value of existing fixed-rate bonds;
liquidity risk: some bonds may be difficult to sell quickly at an attractive price;
inflation risk: fixed payments can lose purchasing power;
call risk: certain bonds may be redeemed by the issuer before scheduled maturity.
Another misconception is that a bond is the same as a stock. A bond generally represents debt owed by the issuer, while a stock represents an ownership interest in a company.
Bond price and face value should also not be confused. TreasuryDirect explains that a bond can trade at par, above par or below par depending partly on the relationship between its interest rate and prevailing yield.