What is a bond? For most, the image of Wall Street is the hot-shot stock trader. With his slick hair, oxford collar and finger on the pulse of the stock market, he’s keenly aware of which companies are today’s winners and losers. Except today, that guy has largely been replaced by high frequency trading algorithms that have made thousands of trades by the time he finishes tying his Windsor knot. And even back in the heydays of the 80s and 90s, most of the real money in high finance was in bonds, not stocks. Because, while owning a stock makes you an owner of a company, owning a bond makes you a lender to a company, which can be a lucrative and less volatile position to be in, especially when the market is full of overblown valuations, volatility and HFTs running the show. You know, like today’s market.
Who issues bonds?
If you’re used to trading stocks, which represent part ownership of a public company, or forex, which is effectively cash, you might be surprised to learn that there are publicly traded bonds issued by institutions other than public companies. Corporations: Companies issue bonds to raise cash, the same reason they go public and issue new stock. However, issuing bonds allows companies to raise money without diluting equity and lowering their stock price. Municipal governments: Local governments and US states issue municipal bonds, called “munis” for short. In some states, the interest payments from owning a muni are tax exempt, which would increase the overall profitability of holding bonds compared to equities. Federal governments: Bonds issued by the federal government are some of the least-risky investments available because they’re guaranteed by the US government. Often known as “Treasuries.” Other institutions: Universities, public transit agencies, and other organizations can also issue bonds as a form of financing. Since these aren’t publicly traded, raising funds through equity isn’t an option.
What is a bond?
A bond is essentially a loan issued by a company, government or other institution. Like any other loan, it has a principal amount, an interest rate and a maturity date — and it’s often resold, just like many mortgages and auto loans. Principal: the original amount of money that was borrowed by the bond-issuing entity — typically a company or government. It’s typically $1,000, which is known as face value. Interest: a fixed or varying amount paid by the borrower (a company or government) to the lender (the bondholder). Usually expressed as a percentage and often paid every six months. Interest is the cost of borrowing (for the borrower) and the benefit of lending (for the bondholder.) Coupon: how bond traders describe interest payments. The annual interest rate determines the amount the bond issuer (the company or government) pays the bondholder (the lender) throughout the lifetime of the bond, typically every six months. These payments are called “coupon payments.” Maturity date: This is the end date for the bond. It’s when the bond-issuing entity (the company or government) must repay the full amount borrowed (the principal) to the bondholder. Bonds are often referred to by their duration – 2-year, 10-year, 30-year, etc. – but each bond, no matter the duration, has a specific end date. Here’s how all those pieces work together:
As an example, let’s take a $1,000 10-year bond with 5% interest. The issuer (a company or government) is essentially taking out a $1,000 loan. You purchase this bond through a broker — more on that in our next article.
The issuer is obligated to pay the bondholder (you) $25 every six months. Why $25? Because 5% of the $1,000 principal is $50. It’s then divided by 2 because the payments are semi-annual. Thus, the bond has a $25 coupon.
In the meantime, you can sell this bond if you want. The bond price you can get might be more or less than its $1,000 face value, depending on the issuer’s creditworthiness and conditions in the overall bond market.
When the bond matures in 10 years, the issuer will pay the bondholder the full $1,000 principal.
So that's the answer to the question what is a bond, but trading in today’s bond market is complex. A strategy can make it simple. We can use our "Genesis Service" to design a bond system just for you. Contact us for details.