What is a Bond?

A bond is a fixed income investment where an investor loans money to an issuing entity, such as a government, a municipality, or a corporation, in exchange for regular interest payments over a specified schedule, or term. At the end of the term, the issuer repays the original amount borrowed, known as the principal, to the bondholder.

Bonds are considered a relatively safer investment compared to stocks and can provide a steady income stream via interest payments. While bondholders may not participate in the gains stockholders might experience, they are above stockholders in the capital structure.  This means in the event of bankruptcy; bondholders have a higher claim than stockholders.

How do Bonds Work?

When an entity wants to raise money, it will issue bonds for investors to purchase with the promise to pay the bondholders back the full principal amount. In addition to repaying the principal, issuers pay periodic interest to bondholders throughout the bond's life, usually on a quarterly, semiannual, or annual basis. The interest rate, or coupon rate, is fixed at the time of issuance and is used to calculate these interest payments. Investors buy bonds at face value, which is typically $1,000 per bond, and can hold the bond until maturity to receive the full principal amount back. Alternatively, investors can sell the bond before maturity in the secondary market, where bond prices fluctuate based on interest rates, credit quality, and market conditions.

Example: A corporation issues a 10-year bond with a face (or par) value of $1,000 with an annual interest rate of 5%, paid on a semiannual basis.  When the bond is purchased, $1,000 is being lent to the issuing corporation. Every year for the next 10 years, the corporation owes 5% (or $50) of the $1,000 par value in interest payments, also called coupon payments.  Since the interest is paid semiannually, the bondholder is paid two payments of $25 every six months.  At bond maturity, the issuing corporation will pay back the full $1,000.

Read also: Selecting the Right Bond For You

Key Terms to Know

Face (Par) Value: The nominal value of the bond, usually set at $1,000, that the issuer promises to pay back at maturity.

Maturity Date: The date on which the issuing entity must pay back the principal amount of the bond back to the bondholder.

Coupon Rate: The annual fixed interest rate that the issuer must pay the bondholder.  Most payments to the bondholder occur on a quarterly, semiannual, or annual schedule. Some bonds may have “floating” coupon rates, which can adjust over time.

Bond Price: The market value of the bond if it is traded on the secondary market. This can fluctuate based on interest rates and other market conditions.

Yield: The return on investment of a bond, which considers the interest payments as well as the bond’s current market price.

Credit Rating: An evaluation of the issuer’s financial health and the likelihood of their ability to repay their debts.  Third party agencies assign ratings to bonds based on the risk of default.  Higher ratings indicate the bond would be considered “investment grade”.  Lower ratings indicate the bond carries higher risk; however, these bonds generally pay higher interest rates to compensate investors for taking on that risk.

Call Feature: A provision that allows issuers to repay the bond before maturity.  An issuer may do this if interest rates fall, and the issuer can issue new bonds at a lower rate in order to save money.  Bonds with a call feature generally have a prespecified call price, as well as guidelines surrounding how early the bond can be called.

Bond Risks

While bonds are widely considered safe, there are some key risks investors should be aware of.

Interest Rate Risk: The risk that rising interest rates will cause a bond’s price to fall. Bond prices and interest rates move in opposite directions, so when rates fall, bond prices rise, and when rates rise, bond prices fall. If an investor wants to sell a bond on the secondary market, that is where the risk would potentially be realized.

Credit (Default) Risk: The risk that the issuer may not be able to make interest payments or repay the principal amount at maturity.  Bonds that have lower ratings carry more credit risk.

Reinvestment Risk: When interest rates fall, bondholders may have to reinvest bond proceeds at a lower rate.  This commonly happens with callable bonds, as the bondholder will receive the principal payment back from the issuer but may not be able to reinvest the funds at a comparable rate.

Inflation Risk: While invested in a bond, the bondholder is usually committed to receiving a fixed rate of return over the term of the bond.  During this time, inflation may increase dramatically, perhaps at a faster rate than the income from the bond.  Upon maturity, the purchasing power of the principal may be eroded.

Liquidity Risk: Depending on the type of bond, the investor assumes the risk of not being about to sell the bond quickly due to the lack of buyers on the market.  When this happens, the price at which the bond eventually sells may be far lower than expected.

Duration Risk: Duration measures the sensitivity of a bond’s price to changes in current interest rates.  Bonds with longer durations are more sensitive to interest rate changes.

Currency Risk: Fluctuations in exchange rates can impact a bond’s returns when converted back into the investor’s home currency.  If a foreign currency weakens after a bond is purchased, it may affect the total value of the bond as well as interest payments.

Bonds at Webull

Check out Webull for a new secure way to invest money! Webull will soon offer Treasury Bonds, Bills, and Notes backed by the U.S. government, which are time-tested investments.

You can start investing with a minimum investment of $1,000. But before investing, visit Webull Learn for valuable information on investing in Stocks, ETFs, and Options. Webull is dedicated to equipping you with the knowledge to make smart investment choices and diversify your portfolio. Keep an eye out for more updates on this new opportunity and elevate your investment experience with Webull.