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What is a Bond?

Jack and Nick Author Pic
Jack Kramer & Nick MartellAugust 26, 2019
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
definition

A bond is like an IOU that’s issued by a company, government, or institution in exchange for cash, and it’s tradable in financial markets, similar to a stock.

🤔 Understanding bonds

When a company needs money, two available options are to sell stock in themselves or to borrow money — and a bond-issuing entity is borrowing money from investors. The bond investors are owed repayment of their funds by the bond issuer, making them lenders. They can sell their bond (which is like an IOU note) to other investors, allowing the bond to trade in the market. The bond issuer pays back whomever owns the bond when it’s due (when it “matures”) and usually makes interest payments (“coupons”) along the way, too. But since companies can go bankrupt, there’s no guarantee a bondholder gets paid back.

Bond_desktop

Figures used in the graphic above are shown for illustrative purposes only. Actual prices, coupon amounts, and yields of a bond may vary.

example

Beer giant AB InBev is famous for owning Budweiser and a bunch of other beer labels. But in 2016, the company needed a large amount of new cash in order to complete its biggest acquisition ever: SAB Miller. To pay for the $100+ billion acquisition, AB InBev completed one of the biggest bond deals in history, issuing $46B worth of bonds. AB InBev is now slowly paying back that $46B in debt from its beer sales.

Takeaway

It’s an IOU you can trade — but they’re not guaranteed…

A bond forms a borrower/lender relationship. The borrower is the company issuing a bond, the lender is the investor who buys a bond. Borrowers get cash for themselves, lenders usually get interest payments. But companies, entities, and governments that issue bonds can go out of business, which could mean the bond investor doesn’t get the IOU repaid.

Tell me more...

What are the key bond terms to know
Who issues bonds?
Types of bonds you’ll see
Bonds in the markets
What are some bond risks?
Bond rating = the bond’s risk level
Are bonds “fixed income”?

What are the key bond terms to know

To understand bonds (which are not offered by Robinhood Financial LLC), it’s helpful to break down the jargon you’ll hear surrounding the concept. Together, these terms are related and form the foundation for the bond ecosystem — as you use each one, you’ll notice it relates to another one of the terms below (“circle of life” style).

  • Principal & Interest: These are the two key financial parts of a bond. The principal is the original amount of money that was borrowed by the bond-issuing entity. The interest is a fixed or varying amount paid by the borrower (the bond issuer) to the lender (the bond owner). It’s usually expressed as a percentage of the principal and often paid semi-annually (every six months). Think of interest as the cost of borrowing, and the benefit of lending.
  • Coupon: That’s another way to describe interest payments — it’s the annual interest rate that determines the amount the bond issuer (the borrower) pays the bondholder (the lender) throughout the lifetime of the bond, typically every six months.
  • Maturity date: This is the end date for the bond. It’s when the bond-issuing company (the borrower) must repay the full amount borrowed (the principal) to the bondholder.
  • Example: With a $1,000 10-year bond at 5% interest, the bond issuer is essentially taking out a $1,000 loan. It will then pay the bondholder (the lender) $25 every six months (5% of $1,000 principal annually, divided by 2 since it’s paid twice a year). Then it will pay the full $1,000 principal back when the bond matures in 10 years.

Who issues bonds?

Bond issuers (the entities that want to borrow) tend to fall into four main groups:

  1. Corporations: Companies issue bonds to raise cash to pay for growth projects, to lease new properties, acquire another company, or to just have more money in the bank.
  2. Municipal governments: Local governments or one of the US states issue municipal bonds. They’re often called “munis” for short. For some investors, depending on where they live, buying a muni bond in their home state has tax benefits compared to other bonds because home-state interest payments could be tax exempt. Robinhood Financial LLC is not a tax adviser, so make sure to consult one for clarity on any tax issues.
  3. Federal governments: Bonds issued by the federal government are some of the least-risky investments available because they’re guaranteed by “the full faith and credit” of the US government and they’re known as “Treasury bonds “ or “Treasuries.” The US government issues Treasuries and uses the funds from the sale to pay for government worker salaries, military contracts, public health initiatives, or any other government spending needs.
  4. Other institutions: Universities, public transit agencies, and other organizations can also issue bonds to finance themselves for things like growth opportunities, like expanding to new countries or building new offices.

Types of bonds you’ll see

Between these four types of issuers, there are plenty of bond types you’ll come across. They’re differentiated with unique features, but all bonds contain some level of risk.

Convertible bonds are corporate bonds that allow the bondholder to exchange the bond for proportionally priced stock in the company. Because the bondholder gets the benefit of the option to convert the bond, the interest rate they earn from the bond issuer tends to be relatively lower than a standard non-convertible bond. The bond issuer gets the benefit of paying a lower interest rate because you get the benefit of convertibility.

Zero Coupon bonds are (spoiler alert) not paying a coupon interest payment to the bondholder. Instead, they are offered at a lower price (a discount) than their final face value. So the investor’s potential benefit is the difference between what he or she pays to buy the bond and the amount repaid at the maturity date. The bond issuer does not make interest or coupon payments along the way.

Callable or puttable bonds are bonds that can be ended early by the issuer or the investor.

  • A callable bond can be “called” (demanded back) by the issuer at certain times before the bond was supposed to mature. The ability to call a bond early is a benefit to the issuer and a cost to the bondholder, so the issuer tends to compensate the bondholder for that with a higher interest rate.
  • A puttable bond can be “put” (sold back to the issuer) by the bondholder at certain times before the maturity date. It benefits bondholders to be able to put a bond back to the bond issuer. To compensate the issuer for that cost, the bond tends to offer a lower interest rate paid to the bondholder.

Bonds in the markets

Just like stocks, bonds trade in public securities markets. You can buy bonds from a bond broker, while government bonds can also be bought directly from government agencies. You can even gain exposure to bonds by buying funds made up of bond investments. No matter how you access bonds, there are two key parts of a bond that are needed to understand its worth: the price and the interest rate.

Interest rates: The value to an investor of owning a bond is primarily the interest rate paid by the issuer. The interest rate an issuer must pay is connected to its creditworthiness — how risky the issuer is, and how likely it is to repay the bond at the maturity date. Investors should expect higher interest rates for riskier bonds.

Prices: Investors can also gain by buying a bond at a discount (lower) price and getting repaid at the full price. The “full price” is known as “face value,” and it’s typically $1,000 for a bond. It’s possible to buy a bond at a discount price like $900 and get repaid the full face value $1,000 at the maturity date. It’s also possible for the $900 bond to lose value if the issuer is at risk of defaulting, or actually does default. Defaulting means not making its legally obligated payments to the bondholder.

Interest rates and bond prices tend to have a see-saw style inverse relationship. When interest rate levels in the economy rise, the price of a bond tends to fall. That’s because the bond’s fixed interest rate (the “coupon rate”) becomes less attractive as interest rates rise — rising rates mean investors can find potentially higher interest rate bonds elsewhere which would be more attractive. As a result, the demand for those existing lower interest bonds falls, pushing their prices down.

What are some bond risks?

Just like with stocks, there are no guarantees that an investor will generate a return from a bond investment. Bonds are considered less risky than stocks because issuers have a legal obligation to repay bondholders, and no obligations to repay shareholders. Investors can use bonds to diversify and lower the overall risk of their portfolios, by balancing what’s invested in stocks. But bond issuers can go bankrupt, and if they do, bondholders can potentially lose their entire investment. In general though, bond prices tend to be less volatile than stocks — but here are two of the main risks.

Default Risk: Defaulting is when a borrower (the bond issuer) fails to pay the interest payments or even the entire principal to the bondholder. This is usually caused by the company becoming insolvent, which is when it’s taken on more debt than it’s able to repay. Defaults are usually connected to bankruptcies, which is a legal process to determine what happens to a company that’s insolvent.

If a company does default, the bondholders may have a relative advantage to other people owed money by the company but may also have a relative disadvantage to other people as well. In a bankruptcy, bondholders may have priority to get repaid before the company’s vendors, employees, and shareholders, but may also be repaid only after the company’s senior or preferred creditors are repaid. However, if a company goes through the bankruptcy process, even bondholders run the risk of not being repaid in full.

Interest Rate Risk: The bond issuer pays the bondholder interest in the form of coupon payments, and the bondholder wants the highest coupon payments possible considering the risk of the bond. If interest rates rise, and other companies (with similar risk levels) start issuing bonds at higher interest rates, that may make your bonds less attractive to investors. The result could be a drop in the price of the bond.

Bond rating = the bond’s risk level

If your buddy asks you to cover their brunch tab, you might do an internal calculation of their ability to pay you back. Credit rating agencies use a similar approach for bond issuers, but typically conduct more rigorous and complex analysis to evaluate an issuer’s creditworthiness. They also publish the results of their analyses, typically called credit ratings, to help investors make decisions.

Credit ratings are produced by separate, third party companies (such as Fitch, Moody’s, or Standard & Poors) to evaluate the financial health and creditworthiness of an issuer of bonds. They evaluate many factors, but the core focus is on evaluating the company’s capability to repay its debts. If its business is enjoying growing sales and profits, its credit rating is more likely to improve than if it is not growing in those areas. If a country hits an economic recession, its government credit rating is more likely to suffer.

  • Investment grade = moderate to minimal risk of default. These are issuers rated Baa or higher (for Moody’s) or BBB or higher (for S&P). The top grade is Aaa or AAA, which is held by just a handful of governments, companies, and other bond issuers.
  • Non-investment grade = substantial credit risk. Commonly known as “junk bonds,” these issuers have high debt levels — investors should know their bonds have a substantially higher risk of default. In return, investors will typically demand higher interest rates to compensate them for all that additional risk they’re taking on.

Rating agencies may have slightly different rating terms, but all follow similar analyses and purposes — help the investor understand how risky the bond is so that they can better decide if it’s the right investment for them.

Are bonds “fixed income”?

Yes. That’s the technical-sounding term you’ll hear used to refer to bonds in general. Since many bonds pay the bondholder a consistent coupon payment, the bondholder is receiving a fixed amount of income from the company that issued the bond. Fixed income investments may be attractive to investors who are retired and rely on their investments for steady income streams to finance their lives.

On Wall Street, banks tend to have “Fixed Income Divisions” which trade the bonds issued by companies, organizations, or governments. Fixed Income Divisions look to profit from bond-trading, with strategies to buy and sell bonds as the bond prices change.

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