Bond
A bond is a debt security, a financial instrument representing a loan made by an investor to a borrower—typically a corporation or a government. The issuer of a bond promises to pay the bondholder a specified amount of interest over a set period and to repay the principal amount at maturity. Bonds are a major source of finance for governments and corporations and a principal asset class for investors.
Definition and basic features
A bond is a contractual obligation under which the issuer (borrower) agrees to pay the holder (lender) periodic interest and to return the principal at a specified future date. The essential features of a bond include:
The face value (or par value or principal) is the amount the issuer borrows and promises to repay at maturity. It is typically set at a round figure such as 1,000 units of currency.
The coupon rate is the interest rate the bond pays on its face value, expressed as an annual percentage. Some bonds are zero-coupon bonds, which pay no periodic interest but are issued at a discount to face value.
The maturity date is the date on which the principal is repaid. Bonds may be short-term (a year or less), medium-term (up to ten years), or long-term (more than ten years), including some with maturities of decades.
The issuer is the entity that borrows the funds. Issuers include national governments, municipal authorities, corporations, and government agencies.
Types of bonds
Government bonds (also called sovereign bonds, treasuries, or gilt-edged securities) are issued by national governments. Because they are backed by the taxing power of the state, they are generally regarded as the safest debt instruments in a country's market and serve as a benchmark for other rates.
Corporate bonds are issued by companies to raise capital. They carry greater risk than government bonds and therefore offer higher yields, reflecting the possibility of default.
Municipal bonds are issued by state, provincial, or local governments. In some jurisdictions, the interest is exempt from taxation, which makes them attractive to certain investors.
Agency bonds are issued by government-sponsored enterprises and agencies.
Convertible bonds give the holder the option to convert the bond into a specified number of shares of the issuer's stock, combining features of debt and equity.
Index-linked bonds have their principal and interest payments adjusted for inflation, protecting the holder's purchasing power.
Bond prices and yields
The price of a bond and its yield are inversely related. When the market price of a bond falls, its yield rises, and vice versa. This relationship is fundamental to understanding bond markets.
The yield to maturity is the internal rate of return earned by holding a bond to maturity, taking into account its current price, coupon payments, and face value. It is the most common measure of the return on a bond.
A fundamental principle is that when interest rates in the economy rise, the prices of existing bonds fall, because newly issued bonds offer higher coupons and existing bonds must be priced to offer a competitive yield. Conversely, when interest rates fall, existing bond prices rise.
The duration of a bond measures its sensitivity to changes in interest rates. Bonds with longer durations are more sensitive to rate changes than those with shorter durations.
The bond market
The bond market is one of the largest financial markets in the world, trading trillions of units of currency each year. It is divided into the primary market, where new bonds are issued, and the secondary market, where existing bonds are traded.
The yield curve plots the yields of bonds of different maturities for a given issuer, usually the government. Under normal conditions, longer maturities carry higher yields, producing an upward-sloping curve that reflects the greater risk of lending over longer periods. An inverted yield curve, in which short-term yields exceed long-term yields, has historically been a strong predictor of recession.
The credit spread is the difference between the yield on a corporate bond and that on a comparable government bond. It reflects the market's assessment of the credit risk of the corporate issuer. Wider spreads indicate greater perceived risk.
Bonds and interest rate risk
Bondholders face several kinds of risk.
Interest rate risk is the risk that interest rates will rise, reducing the market value of existing bonds. It is greater for longer-maturity bonds.
Credit risk (or default risk) is the risk that the issuer will fail to make payments. Default risk is assessed by credit rating agencies such as Moody's, Standard & Poor's, and Fitch, which assign ratings to bonds ranging from high-quality investment grade to speculative or "junk" status.
Inflation risk is the risk that inflation will erode the real value of the bond's fixed payments.
Liquidity risk is the risk that a bond cannot be sold quickly at a fair price.
Reinvestment risk is the risk that the proceeds of a bond's coupons or maturity will have to be reinvested at lower interest rates.
Bonds in the economy
Bonds play several essential roles in the economy. They provide a channel through which governments finance public expenditure and firms finance investment. They give savers a means of earning a return while limiting risk. They serve as a benchmark asset for pricing other securities and for measuring risk. The government bond market in particular provides a risk-free reference rate and a liquid instrument for managing liquidity.