A bond is a loan. It’s nothing more than a fancy IOU in which the terms, pay-back date and interest rate are carefully spelled out in a legal document.
It’s like in any relationship, it’s a promise made by both sides. In business term, it’s an approach in finance. When they need something today, they promise to pay for it at some point in the future. And those promises are called bonds.
There are millions and millions of bonds issued every year. And the bond market in its entirety is staggeringly large. The total value of all outstanding bonds in the global market is approximately $61 trillion, according to the Securities Industry and Financial Markets Association. By comparison, the total value of shares of stock in the global markets is about $50 trillion.
Types of available bonds – from Treasury Notes and TIPS to Cat bonds and Bowie Bonds. There are the reasonably safe bonds that are called “investment grade.” Then there are the riskier bonds called “below investment grade,” “high yield,” and — most tellingly — “junk bonds.”
To make matters even more confusing, bonds of all types are sometimes referred to by different names. Sometimes bonds are called fixed-income securities. Sometimes they are called debt securities.
There’s a “primary market,” which is where bonds are sold for the first time. Then there’s the “secondary market,” an often confusing and hidden part of Wall Street where bonds can be traded.
But no matter what you call them and no matter where you buy them, nearly all bonds share some common traits:
1. Face Value – When a bond is created it is given a certain face value, sometimes called the par value or the principal of the bond. Just as in a personal loan, the principal refers to the amount of money the borrower must return to the lender at the end of the loan term. By tradition, bonds in the U.S. are almost always given a face value of $1,000. Thus a bond issue of $100 million, in which a corporation is looking to borrow $100 million from investors, will involve the sale of 100,000 bonds with face values of $1,000 each.
2. Interest rate – Nearly all bonds pay an interest rate (The exceptions are zero-coupon bonds and “strips.”) Those rates tend to have an easily understood relationship to risk. The more likely it is that a bond issuer will default on a loan, the higher the interest rate he must pay to attract investors. Interest rates are calculated as a percentage of the bond’s face value. And by tradition, interest payments are made on bonds twice a year. The annual interest rate on a bond is called the yield.
3. Maturity Dates – Bonds don’t live forever. Each of them has an expiration date, or maturity, at which time the bond issuer must return the principal to an investor. Some bonds have a very short life span. Others last for decades. As a rule of thumb, bonds that mature in less than five years are called short bonds. Those that mature in five to 12 years are called intermediate bonds. Long bonds have maturities of 12 years or more.
4. Credit Agency Rating – How safe is your bond? How likely is it that the issuer will collapse and default on the loan? Will the issuer have enough cash flow eight years from now to make interest payments? These are complex questions that require considerable time and study to answer. Fortunately, you don’t have to do the work. There’s an entire industry dedicated to determining the safety of bonds and sharing that information with brokers and investors.
These credit rating agencies – Moody’s, Standard & Poor’s (S&P), Fitch Ratings, A.M. Best, and others – assign letter grades to bonds. With a glance you can tell that a bond with an A rating from Moody’s is considered much safer than a bond with a CC rating from Fitch. However, it’s worth noting that the collapse of the mortgage-backed securities market in 2007-08 showed that even the experts at the credit agencies found it difficult to analyze some of the complex bonds and derivatives that Wall Street created during the housing boom.
By learning to understand and compare these common factors, you’ll be able to navigate through the complex world of fixed-income investing and determine which bonds work best for your portfolio.