What is a Bond?When organizations need money they often borrow it from others. They can of course go to the bank like me or you. Alternatively, many find it cheaper to issue debt directly to investors. This is done with bonds.
A bond is nothing more than a fancy IOU. It is a certificate stating that someone (or some organization) owes you money. This money is usually in the form of principal (what the investor game to the organization) as well as interest for the use of the money.
Many types of organizations issue bonds. They range from corporations, to nations, to local governments, to schools. The most common type of bond is called a fixed coupon bond.
A coupon bond is a bond that pays a periodic interest payment to the bond owner. Bonds are usually sold in the primary market with a coupon rate (the annual percentage of principle that is paid out) equal to the prevailing market interest rate on other bonds of equal risk.
For example a 10% fixed coupon rate bond with a 10 year life and annual payments would pay out 10% of the amount of the loan (also called the Par Value and usually equal to $1000) each year.
Most bonds in the US pay interest semiannually. Therefore a 9% semi-annual coupon bond with a par value of $1000 would pay $45 every six months.
At some point in the future almost all of these bonds must be paid off. This time is called the maturity of the bond. Bonds can have maturities (when they are paid back) ranging from a few years to many years. When the bond matures the investor gets the last interest payment back as well as the principal (AKA par) value back.
Like stocks, we can differentiate between the primary market (where the firm sells the bond to the public) and the secondary market (where bond investors sell to other bond investors). The firm only gets money for selling in the primary market.
Bonds are extremely sensitive to interest rates. A central tenet to bond investing is that bond prices move in the opposite direction of interest rates. Therefore, rising interest rates are bad news for bond investors and falling rates are good news.
Without getting too detailed this is because if interest rates in the market go up, there are other firms selling comparable bonds at the new, higher, interest rate. To get investors to buy the old bonds, their price must fall.
The longer the life of the bond the more sensitive the bond is to interest rates. This can be measured with Duration which is a bit beyond the scope of these notes.
There are many types of bonds. They range from the straight coupon
bonds that we have seen to zero coupon bonds (where the firm pays only
the principle back...these are sold at a discount so the single lump sum
at maturity is both interest and principle), to floating rate bonds.