Understanding the Basics of Bonds

29
September

Beginning investors are overwhelmed by an extraordinary amount of information about developments in each of the financial markets and how they affect one another. Although that is the case, understanding a given market is as simple as learning the basic structure of that market. Once this is done and some basic terms are memorized and incorporated into the investor’s basic thinking process, understanding finance is relatively simple.

For many first-time investors, the stock market seems much more attractive than the bond market, especially during times of bubbles, since the returns on stocks seem to greatly exceed the returns on bonds. Nevertheless, bonds have one major advantage that stocks do not: stability. This article will examine why bonds are such stable investments and show investors than the bond market is a worthy alternative to stocks.

What Are Bonds?

Bonds are debt securities, which means that bond investors hold a portion of the total debt of a government, company, or municipality such as a state or city. A bond is essentially a contract between the investor and the government, city or company from which the investor received the bond. The investor lends a certain amount of money to an entity, who then gives the investor a bond as a receipt. The amount of money for which the bond was bought or issued is known as the bond’s face value.

Since investors do not lend their money without compensation, the entity issuing the bonds pays the bondholders interest on their investment. This is called the bond’s coupon. All bonds are time-limited, which means that they have to be repaid to the investor at a certain date, which is called the maturity date.

Thus, when an investor buys a bond, they hold a portion of the bond issuer’s debt. Obviously, bonds bought from cities or governments are much more stable than corporate bonds. There are two factors that determine how large of a coupon a certain bond possesses. These two factors are credit quality and duration. It is quickly noticed upon reflection that the more creditworthy an issuer is, the less interest the bond will have. This is because the coupon is meant to compensate the investor for their risk is lending money to the bond issuer. If the bond issuer is known for repaying their debts, the investor takes on less risk, and thus is paid a lower coupon.

How The Bond Market Works

Bonds are classified according to the type of issuer. Therefore, there are several varieties of bonds:

- U.S. government securities such as Treasury bills
- Municipal bonds from state, city and local governments
- Corporate bonds that are issued by corporations and businesses
- Asset-backed securities such as mortgage-backed securities
- Federal agency bonds
- Bonds issued by foreign governments

Investors can purchase bonds from any of these issuers, which have a varying level of risk. There are also different types of bonds within an issuer class, such as high-quality corporate bonds versus so-called “junk bonds”. Junk bonds are issued by less creditworthy companies, but the attraction is that they pay a higher interest rate. High-quality corporate debt is issued from standing companies that have a strong reputation for repaying their debts, and thus pay lower coupon rates than junk bonds.

It must be understood that the interest rate varies from issuer to issuer based upon market conditions. For example, the coupon rate on mortgage-backed securities is directly related to the current mortgage rates. So, if mortgage rates are falling, the interest rate on mortgage-backed securities is also falling.

Buying and Selling Bonds

Here is the first confusing part about understanding bonds: the face value of the bond is not the same as the price of a bond. The price of a bond can actually change on a daily basis. This is because while bonds are designed with the maturity date in mind, investors do are not required to hold bonds to maturity. A bond’s yield is the expected return for a bond. If the coupon on a $1,000 bond is 10%, the yield is 10%, which is 10/1,000.

A bond buyer wants a higher yield because they want to get their bonds at a discount. A bond seller, on the other hand, wants the price to go up so they can sell it at a profit.

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

Email  • Google + • Twitter

Comments are closed.