What Is a Bond? An Easy Guide to Understanding Bonds

A bond is a fixed-income financial instrument that investors issue to borrowers (the people who lend money). What does that mean? In this post, we'll explain in simple terms what bonds are, how they work, the different types, and more.

The post is a bit long, but if you've ever wondered what a bond is, I think you'll find it worthwhile to read all the way through. Ready? Then let's get started!

The Concept of a Bond

Bonds are usually issued by companies or governments. A company or government borrows funds from lenders and provides a bond as proof of the loan. Simply put, a bond is "proof that someone has borrowed money from you and will repay it with interest by a certain date."

• Bonds are usually issued by companies or governments and are tradable securities.
• Bonds are considered fixed-income products because they basically pay a fixed interest rate to the lender. These days, however, there are also many floating-rate bonds.
• Bond prices move in the opposite direction of market interest rates. In other words, when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
• Bonds have a maturity date, at which point the principal is either fully repaid or the bond goes into default.

To sum up, a bond is a kind of IOU. In other words, it's proof of the "right to be repaid a debt," confirming to the lender that the borrower has borrowed the money. The word "bond" may sound a little intimidating, but you can think of it as an IOU. When you write an IOU, you borrow money for a set period and then have to pay back the principal plus interest on the due date. Bonds work the same way.

However, there is one difference between a bond and an IOU: the "right to be repaid a debt" can be bought and sold. In other words, this right can be traded with someone else on the market.

Why Bonds Are Issued

Governments and companies usually use bonds to raise funds. Governments sometimes need to raise money to build roads, schools, dams, or other infrastructure. At times, they may also need to fund sudden defense expenses.

Likewise, companies may want to borrow money to grow their business, buy property and equipment, invest in projects, hire new employees, and so on. Large companies usually need far more money than banks can provide.

Through bonds, many individual investors can become lenders and lend money to governments and companies. In fact, on the public bond market, countless individuals buy bonds to lend money to governments and companies, and they actively trade these bonds with other investors as well.

How Bonds Work

A bond is a fixed-income product: a financial instrument in which investors lend money to a company or government and receive regular interest (coupons) in return. Along with stocks, bonds are one of the asset types best known to individual investors.

• 1. Issuance and trading: When a company or government wants to raise new funds, it issues bonds. The issuer specifies the loan terms, interest rate (coupon rate), repayment schedule, and so on, and sells the bonds to investors. Investors hold the bonds and receive interest regularly until maturity.
• 2. Market pricing: A bond's initial price is usually set at its face value, but the actual price it trades at on the market changes depending on the issuer's creditworthiness, the time to maturity, and current market interest rates. When market rates fall, the value of existing bonds rises; conversely, when rates rise, bond values fall.
• 3. Bond liquidity: Most bonds can be sold to other investors after they are issued. Investors can sell their bonds and realize a profit without holding them until maturity. In particular, if market rates fall or the issuer's creditworthiness improves and the bond price goes up as a result, you can lock in a gain.

Features and Components of a Bond

Most bonds share the following common features and components. These are important factors that determine a bond's value and investment return.

1. Face Value

A bond's face value is the principal amount the bondholder will receive at maturity. It is also the amount the issuer uses as the basis for calculating interest payments.

For example, let's say one investor buys a bond with a face value of $1,000 for $1,090, and another investor buys the same bond for $980. At maturity, both investors will be repaid the face value of $1,000.

2. Coupon Rate

The coupon rate is the interest rate the bond issuer pays the bondholder, based on the face value. For example, if a bond with a face value of $1,000 has a coupon rate of 5%, the holder will receive $50 in interest every year.

3. Coupon Dates

Coupon dates are the dates on which the bond issuer pays interest. Interest is usually paid semiannually or annually.

4. Maturity Date

The maturity date is the day the bond matures, the point at which the issuer must repay the principal (face value) to the bondholder.

5. Issue Price

The issue price is the price at which a bond is sold when it first comes to market. It can differ from the face value, and depending on market conditions, the bond may trade at a discount or at a premium.

6. Credit Quality

If a bond issuer has low creditworthiness, it means the risk of default is high. As a result, such bonds tend to pay higher interest than other bonds. Bonds with low credit ratings are called "high-yield" or "junk bonds." These bonds offer higher coupon rates, but they also carry correspondingly higher risk.

7. Time to Maturity

The longer the time to maturity, the higher the interest rate the investor can receive. This is because the investor is exposed to interest rate changes and inflation for a longer period.

Types of Bonds by Issuer

Bonds traded on the market can be broadly divided by issuer into government bonds, corporate bonds, municipal bonds, and agency bonds. Of these four types, government bonds and corporate bonds are the most widely traded and the most popular on the market.

First, government bonds (treasuries) are bonds that a country issues to raise funds. In the United States, for example, short-term bonds of one year or less are called "bills," bonds maturing in 1 to 10 years are called "notes," and long-term bonds of 10 years or more are called "bonds." Because government bonds are backed by the credit of the nation, they are very stable, and unless the country ceases to exist, there is almost no chance of not being repaid the principal and interest.

Corporate bonds are bonds that companies issue to raise funds. Companies can raise money at a lower cost than bank loans, and investors can expect higher interest rates than bank deposit rates. However, if a company's finances are unstable, there is a risk of default, so it's a good idea to carefully assess the company's risk before investing.

Municipal bonds are issued by local governments and are used to raise public funds. Some municipal bonds also offer tax exemptions, giving investors additional benefits.

Finally, agency bonds are issued by government-affiliated organizations, which issue them to raise funds.

Types of Bonds by How They Work

Bonds can also be classified by the type of interest, how interest is paid, and whether the issuer can call the bond back.

First, a zero-coupon bond is sold at a discount at issuance without regular interest payments, and the investor earns a return by receiving the face value at maturity. For example, a zero-coupon bond bought for $800 is redeemed at its face value of $1,000 when it matures. Because zero-coupon bonds pay no interest, investors only earn a return at maturity.

A convertible bond gives the investor the option to convert the bond into shares of the issuing company under certain conditions. For example, when a company issues a convertible bond with an 8% interest rate, it may grant the right to convert the bond into shares once the stock price rises above a certain level. Convertible bonds have relatively low interest rates, but they are popular with investors who hope to profit from converting into stock.

A callable bond is a bond whose issuer has the right to redeem it before maturity. For example, if interest rates fall five years after a bond is issued at a 10% rate, the issuer can call back the bond and issue a new one at a lower rate. So when investing in callable bonds, you should always keep in mind that the issuer may call them back.

The Key to Bond Investing: Interest Rates and Prices

Like other securities traded on public markets, bond prices change every day. However, bonds have some unique pricing mechanics. First, bond prices depend on market interest rates. This is because, in the case of fixed-rate bonds, the issuer has promised to pay interest based on the bond's face value.

Let's look at an example. Suppose there is a bond with a face value of KRW 10,000,000 and an interest rate of 10%. This bond pays KRW 1,000,000 in interest every year.

Now suppose market interest rates fall to 5%. In this case, newly issued bonds on the market will offer a 5% interest rate. But because the existing bond still offers a 10% interest rate, it looks more attractive to investors.

As a result, the price of the existing bond rises. In fact, investors will be willing to pay a higher price for this bond in order to receive 10% interest (KRW 1,000,000). In this case, the bond's market price could rise to around KRW 20,000,000. That's the price at which you would receive KRW 1,000,000 in interest even at the 5% market rate.

To sum up, when market interest rates fall, the rates on newly issued bonds will also fall, so the prices of existing bonds that pay more interest go up.

In other words, bond prices and market interest rates move in opposite directions. When market rates rise, the prices of existing bonds fall, and conversely, when market rates fall, the prices of existing bonds rise.

Wrapping Up

A bond is a security issued by a company or government, a financial instrument sold to investors to raise funds. Bond buyers receive the bond's face value plus interest at maturity, and they can also realize profits from changes in the bond's price before maturity. Because bond prices tend to move opposite to interest rates, bonds are also regarded as an important barometer of future interest rate trends.