Bond

What is a Bond?

A bond is a fixed-income financial asset that represents a debt obligation. When you buy a bond, you are essentially lending money to the issuer — typically a corporation, municipality, or government — in exchange for regular interest payments (called coupon payments) and the return of the principal (face value) at a specified maturity date.

Bonds are a tradable asset that can be bought or sold on the secondary market after they have been issued. They play a critical role in financial markets, providing a mechanism for governments and companies to raise capital while offering investors a relatively predictable income stream.

How Bonds Work

When an entity issues a bond, it agrees to the following terms:

• Face value (par value) — The amount the issuer will repay at maturity, typically $1,000 per bond.
• Coupon rate — The annual interest rate paid to bondholders, expressed as a percentage of the face value.
• Maturity date — The date on which the principal is repaid to the investor.
• Coupon payment schedule — How often interest is paid (annually, semi-annually, or quarterly).

For example, a $1,000 bond with a 5% coupon rate and semi-annual payments would pay $25 every six months for the life of the bond, then return the $1,000 at maturity.

How to Calculate the Value of a Bond

The value of a bond is calculated by taking the present value of all future interest and principal payments. This can be done using the Discounted Cash Flow (DCF) method.

The present value is obtained by using a prevailing interest rate, also known as the discount rate. The relationship between the discount rate and bond price is inverse:

• The higher the discount rate, the lower the price of the bond.
• The lower the discount rate, the higher the price of the bond.

This is why rising interest rates cause existing bond prices to fall, and falling interest rates cause bond prices to rise.

Types of Bonds

By Interest Structure

• Fixed-rate bonds pay a fixed amount of interest regardless of prevailing market rates. Examples include Treasury bonds, corporate bonds, and mortgage-backed securities.
• Variable-rate bonds (floating-rate notes) have interest payments that adjust based on a benchmark rate, such as the federal funds rate or LIBOR/SOFR.
• Zero-coupon bonds pay no periodic interest. Instead, they are sold at a discount to face value and the investor receives the full face value at maturity.

By Issuer

• Government bonds — Issued by national governments. US Treasury bonds are considered among the safest investments in the world.
• Municipal bonds — Issued by state and local governments, often offering tax-exempt interest.
• Corporate bonds — Issued by companies to fund operations, expansions, or acquisitions. They carry higher risk but offer higher yields than government bonds.
• High-yield bonds (junk bonds) — Corporate bonds with lower credit ratings that offer higher interest rates to compensate for increased default risk.

How Interest Rates Affect Bond Prices

Interest rates and bond prices have an inverse relationship. When the base interest rate increases, the fixed coupon rate on an existing bond becomes relatively less attractive, so the bond's market price must decrease to offer a competitive yield. Conversely, when interest rates decrease, the fixed coupon becomes more attractive, and the bond's price rises.

This is a critical concept for bond investors to understand, especially when considering the duration of their bond holdings. Longer-duration bonds are more sensitive to interest rate changes than shorter-duration bonds.

Advantages of Investing in Bonds

• Predictable income — Bonds provide a regular stream of interest payments, making them attractive for retirees and income-focused investors.
• Lower volatility — Bonds are generally less volatile than stocks, providing stability to a diversified portfolio.
• Capital preservation — High-quality government bonds help preserve capital, especially during market downturns.
• Portfolio diversification — Bonds often move inversely to stocks, helping to reduce overall portfolio risk.
• Priority in liquidation — In the event of a company's bankruptcy, bondholders are paid before shareholders.

Risks of Investing in Bonds

• Interest rate risk — Rising interest rates cause bond prices to fall, which can result in losses if you sell before maturity.
• Credit risk (default risk) — The bond issuer may fail to make interest or principal payments. Investors should evaluate the issuer's creditworthiness before investing.
• Inflation risk — Fixed interest payments may lose purchasing power during periods of high inflation.
• Liquidity risk — Some bonds, particularly corporate or municipal bonds, may be difficult to sell quickly at a fair price.
• Reinvestment risk — When a bond matures or is called early, the investor may have to reinvest at lower prevailing rates.

How to Buy Bonds

If you want to buy bonds, there are several options:

1. From your broker — Similar to stocks, you can buy bonds directly through your brokerage account on the secondary market.
2. Using an ETF — Exchange-traded funds (ETFs) that hold a basket of bonds provide instant diversification across issuers, maturities, and credit qualities. This is one of the easiest ways to gain bond exposure.
3. Directly from the government — In the US, you can purchase Treasury bonds directly from TreasuryDirect, avoiding brokerage fees.
4. Through mutual funds — Bond mutual funds are professionally managed and offer diversification, though they typically charge management fees.

Bonds vs. Stocks

The Bottom Line

Bonds are a fundamental component of a well-diversified investment portfolio. They offer predictable income, lower volatility, and capital preservation benefits that complement the higher growth potential of stocks. Understanding the relationship between interest rates, credit risk, and bond prices is essential for making informed fixed-income investment decisions. Whether purchased individually or through ETFs, bonds provide a reliable way to generate income and manage portfolio risk.