Definition of bond

A bond is a debt security, a highly reliable financial market instrument with moderate profitability. It is something like an IOU between the creditor and the borrower that features the crediting and payback details. Most often, bonds are used by investors to create a balanced investment portfolio.

When a purchase of bonds is conducted, an investor provides the issuer with a certain sum for future use. In exchange, the issuer promises to pay the investor a certain part of this sum over a set time and settle the full amount at the end of the loan period. Unlike the shareholder, the bondholder does not normally have any rights to a share in the company or to receive dividends.

Main characteristics of bonds

  • Principal or Face Value – this is a sum that will be paid back to the investor when the bond expires. It can be paid in parts, as long as the expiry date is approaching
  • Issue price – the initial price at which the issuer sells the bond. As a rule, it equals face value
  • Time of Maturity – the timeframe that shows the investor when the company will pay back the borrowed sum. Expiry dates may vary from several months to 30 years
  • Coupon or interest – this is the revenue paid to the investor. Coupons may be fixed or floating. Normally, interest is paid by a certain scheme until the expiry date

Where to buy bonds?

  • Primary market – this is where issuers sell their bonds
  • Secondary market – this appears later when some investors sell their bonds to others. Prices in the secondary market change depending on the supply/demand balance, interest, inflation, how many coupon payments are outstanding, and how much time is left until the expiry date.

The total income from investing in bonds consists of two things: the paid interest (Coupon income) and the difference between buy and maturity prices (discount income).

Types of bonds

Depending on the issuer, there are three main bond types:

  1. Government bonds (treasury bonds, federal loan bonds) are issued by the government of a country. As long as these bonds are fully supported by the government, they are considered to be the most trustworthy ones. However, the interest earned is much lower than for corporate ones.
  2. Municipal (regional) bonds are issued by municipal entities (such as a city, region, etc.) for the purpose of raising money for various social projects. As a rule, the income from such bonds is non-taxable.
  3. Corporate bonds are debt instruments issued by a company that needs to raise capital for expansion, development, and the introduction of novelties. Interest on these bonds is taxable Moreover, the return on such bonds is normally higher.

Bond credit rating

Bonds are rated by various international agencies, such as Moody’s or S&P, to help investors establish their trustworthiness. While securities with a high rating are very reliable, the return on them is rather low. Bonds with a low rating imply increased return, but carry increased risks with it: the issuer might be paying out coupons irregularly, with an overdue maturity day, or they may even go bankrupt.

  • Rating A is given to the most reliable issuers, such as governments or large companies
  • Rating B is the middle level of trustworthiness, meaning the investor somewhat risks losing the invested money. As a norm, this rating is given to issuers with a good business and payment history
  • Rating C shows that the issuer does some risky business and it is highly probable that they will not pay on time or not return the investment at all
  • No rating means that no rating agency has ever rated the issuer, and all the risks can only be estimated by the investor

Advantages and drawbacks of bonds

Strengths:

  • Saving capital – Highly rated bonds are a more reliable instrument than stocks. They are less prone to market risks and help investors save their capital
  • Stable income – Bonds bring in a fixed sum as income on certain calendar days in the form of coupon payments
  • Diversification – Investing in bonds, stocks and other assets helps create a balanced investment portfolio, aiming for profit and stability in conditions of market turmoil

Weaknesses:

  • Relatively low return – Bonds are not as profitable as stocks and many other assets. If inflation grows above the coupon income, the purchasing power of the investor’s capital will shrink.
  • Risk of interest rate changes – When interest rates of Central Banks increase, prices of bonds fall. Interest rate fluctuations are the main reason for the instability in the bonds market
  • Credit risk – Risk of non-refund is the probability that the issuer might not fulfil their debt obligations. Increased credit risks are characteristic of highly profitable bonds with a low rating