Oxford Dictionary

Bond — [noun] A certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time.

ELI5

Let’s not forget about the bond – which, out of the major investment types including bank products, stocks/mutual funds, are generally the least risky. For investors looking for higher returns than bank products, but a steady rate of return this investment type is likely a good fit.

A bond is a fixed-income investment which an individual lends money to a group – typically either a company or government. Normally, the institution issuing the bond needs cash at the moment to fund or support a project. An investor agrees to lend the entity money but expects repayment with periodic interest payments.

As mentioned, bonds are the safer investments since they offer you a fixed periodic payments over the time of ownership of the bond. However, the risk levels can vary depending on who is issuing the bond.

Consider a bond issued by a 2-person startup that has no revenue vs. a bond issued by the US government – which one sounds like a safer investment? Hopefully you answered the US government bond since they are less likely to default. As a result, the coupon rate will be lower for the US government bond vs. the startup’s bond. You’ll make more money via interest investing in the startup but are exposed to a higher likelihood of not receiving your initial investment back.

 

Detailed Definition

Bonds are simple in theory, but there are a handful more concepts that are important to understand before investing in them. Here are some of the terms you’ll encounter when purchasing a bond from a brokerage.

A bond investor purchases the bond from the issuer at face value, or par value. The initial principal invested will be paid back at the maturity date or length that the bond is held for. Bonds can be short-term typically less than 10-years (also called notes) and long-term which tends to be 10-30 year terms.

The coupon rate of a bond is the interest rate that will be paid over the lifetime of the bond, and this tends to be in semi-annual or annual payments. These fixed payments make bonds a fixed-income, steady investment that do not change as the bond matures.

Bonds are inherently tied to interest rate. This is best explained with an example. Let’s say you purchase the bond at a face value of $1,000 with a coupon rate of 5% annually with a 2-year maturity date. So every year you’ll receive $50 dollars worth of interest on the bond.

Now let’s say market interest rates go up to 10% and another investor wants to purchase the same bond. With prevailing interest rates being higher than the coupon rate, the bond becomes less attractive to buy, and the buyer is less inclined to pay the current face value of $1,000. Instead they will pay less than face value to acquire the bond – thus purchasing the bond at a discount. Without this discount, the buyer could purchase a newly issued bond that will pay the better coupon rate of 10%.

The other major term worth noting is bond yield. With a bond, there are two main methods of making money – one is through the periodic interest payments and the other is by purchasing the bond at discount. To capture the entire return on investment, investors commonly use the bond yield. This formula is for adjusted bond yield:

[Coupon Rate/Market Price] * 100 + [Premium/Discount Delta/YTM]

There are a variety of bonds, but they tend to be characterized based off of credit quality and duration. It is akin to the factors affecting an individual’s credit score. The main bond categories are government, investment-grade corporate, high-yield corporate, and mortgage-backed bonds.

Treasury bonds are the lowest yielding bonds, but they are one of the hardiest investments since they are backed by the US government (so almost zero credit-risk). One other benefit is that interest from treasury bonds are tax-exempt. There are also large federal agencies (or government sponsored-enterprises, GSE) like Fannie Mae, Freddie Mac that offer government bonds at higher yields, but they don’t offer the same tax benefits and have a small, but non-zero credit-risk.

Investment-grade bonds are issued by corporations that have a high credit rating by a third-party rating agency (Standard & Poor’s, Moody’s) typically greater than or equal to BBB. The rating system goes from AAA for highest quality, AA is a step down, A, BBB, etc. These companies are equivalent to an individual with a high credit rating – they have a strong balance sheet where there assets are greater than liabilities and are typically generating profits. As a result, they offer higher yields than most treasury bonds, but also contain substantially more risk. Investment-grade bonds are safer than stocks for a couple reasons including the scenario the company does go bankrupt, bondholders will receive their principal before shareholders receive their bit.

High-yield bonds, more affectionately known as junk bonds, are also corporate issued bonds with higher yields than investment-grade corporate since they are offered by companies with a below BBB rating. These companies run the highest risk of bankrupting, but the higher yields attract many investors. Many companies issuing these bonds are in a high-growth stage where it might make sense to purchase the company’s stock instead if possible.

Mortgage-backed bonds are another major type of bond and a little unorthodox to the ones discussed above. For an MBS, a bank will pool together similar mortgages into a bundle and then sell this bundle to a government sponsored-enterprise like Fannie Mae or Freddie Mac as collateral. These MBS’ from GSE are more vetted and less risky than some that are actually offered by private firms that might pool mortgages together from less creditworthy individuals. MBS also tend to pay monthly (as mortgages are) and the investor isn’t solely receiving interest — but also principal in each of the payments.