Bonds are generally considered less risky investment than stocks, and often viewed as a stable form of investing. However, their many names can be confusing. So let’s explore what a bond is and decode bond jargon. Bonds are usually issued by large companies or governments, as a way to borrow money from investors to fund expansion or capital expenditure. This form of debt is known as a bond.
Corporate bonds are issued by companies and Treasury bonds are issued by governments. Companies or governments promise to pay a fixed rate of interest and repay the original loan at specified future date. Investors buy bonds with the intent of preserving their initial investment plus the accumulated interest.
Consider this example - a company wants to fund its expansion into a new market, so it decides to issue bonds to raise money. Each bond is a loan for $1,000, which the company promises to pay back in 3 years, with an annual interest rate of 5%. We have now introduced the three most important components of a bond - $1,000 is a bond’s par value, also known as face value or principal, 3 years marks its maturity date, and 5% annual interest is called the coupon rate.
If an investor buys the bond at par value, $1,000 in this case, they expect to receive a coupon of $50 every year, and then collect the principal when the bond matures in year 3.
Then there is yield. When we talk about yield, we’re really talking about Yield to Maturity or YTM. Yield to Maturity is the total return, interest plus capital gain, obtained from a bond held to maturity. It is expressed as a percentage and tells investors what their return on investment will be if they purchase the bond and hold on to it until the bond issuer pays them back.
As bonds offer regular coupon payments and a return of the principal, they are often viewed as predictable and stable. However, as with many things in life, even the safest investment comes with risk. One of the risks facing bondholders is that the issuer may default. This means the issuer may not pay back the principal, due to financial hardship or bankruptcy. This is referred to as Credit Risk.
To help investors evaluate the financial stability of bond issuers, several credit rating agencies assign rankings to different bonds to assess their credit risk. The three largest credit rating agencies are Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
Bonds can be either rated investment grade or non-investment grade. Non-investment grade bonds, also called high-yield bonds, offer higher yields than investment grade bonds but have a higher possibility of default.
We often use the term fixed income to describe bond investments, with “fixed-income securities,” “debt securities,” and “bonds” often used interchangeably.
