In this video, we'll cover the fundamentals of bonds including what they are, how they work, and how they are priced.
Introduction to Bonds
What is a Bond?
A bond is a fixed income security issued by a company or a government to raise capital or cash to finance operations, investments, acquisitions, and so on. The borrower is known as the issuer and the lender is known as the bondholder in exchange for capital.
The borrower promises to make interest payments to the lender and eventually repay the principal or amount borrowed at maturity. The interest payments the issuer makes can be fixed or variable. A fixed interest rate would be, let's say, five percent and it wouldn't change based on interest rate fluctuations in the market.
A variable or floating rate bond, on the other hand, would change based on short term interest rate benchmarks like LIBOR, which stands for London Interbank Offered Rate.
There are other benchmarks that can be used, but LIBOR is currently the most popular. For example, a floating rate bond might pay at LIBOR plus 300 basis points, meaning that you should add three percent to the library reading at a certain time.
Remember that 100 basis points equals one percent. So when we say library plus 300 basis points, the 300 basis point stays constant. But LIBOR fluctuates based on interest rates in the market.
Types of Bonds
We have bonds issued by governments in the United States. They're called Treasury bonds or Treasury bills, bonds issued by companies or corporate bonds and bonds issued by municipalities and local governments known as muni bonds.
There are a few key terms to know when we talk about bonds.
The principle is the amount borrowed. If a company borrows a hundred million dollars, that is known as the principal and that is the amount that ultimately has to be repaid as well as a bondholder.
You don't have to buy the whole hundred million dollars in bonds. You can buy a slice of it. Just like buying a stock. When you buy a slice of the equity, you can buy a slice of a larger bond offering the par value or face value of one particular bond is the amount that one particular bond promises to pay.
Most bonds have a par value of a thousand dollars, meaning if you own one bond, then you're promised to be repaid a thousand dollars for that bond. The coupon rate is the interest rate. If a bond has a five percent fixed coupon rate and its face value is a thousand dollars, then the bond pays 50 dollars of interest each year.
Key Bond Terms
Payment Frequency
How often does it pay that interest? That depends on the payment frequency.
A bond that pays semi-annually pays twice per year and quarterly would be four times per year. Note that the total payments would still equal the annual coupon regardless of the payment frequency.
Maturity
The bond maturity is the date that the principal is due and the bondholders should receive the face value of their holdings, hopefully in full, if the issuer didn't default. The bond yield is the annual rate of return that would be earned if the issuer made all its payments on time. It's your expected reward if everything goes right.
Yields
We’ll discuss bond yields in greater depth in another tutorial. But for now, you should know that safe bonds traded low yields, i.e. the reward is lower because the risk is lower and riskier bonds have higher yields, i.e. the reward has to be higher to induce investors to take on the extra risk. As an investor, extensive research is required to determine whether a company will be able to repay its debts and therefore whether a particular bond is a good investment.
The key to success is finding Bonds whose yields are higher than the associated risk. But that's not an easy task, and very few investors are able to do that successfully over a long period of time.
Bond Price
One last point on bonds. When you buy a bond, you could buy it at a premium or a discount. If the face value is a thousand dollars, you might be willing to pay over a thousand dollars if the company's credit or outlook for repayment is positive and you might pay less than face value or par value. If the opposite is true. So bonds could trade at a premium or a discount. And that is very important to consider when we discuss bond yields.