An instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity date. Interest is usually payable at fixed intervals (semiannual, annual, and sometimes monthly!). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market. This means that once the transfer agents at the bank medallion stamp the bond on the second market it becomes highly liquid.
Thus it’s a form of loan or IOU: the holder is the lender (creditor), the issuer is the borrower (debtor), and the coupon is the interest. They provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or short term commercial paper are considered to be money market instruments and not bonds: the main difference is in the length of the term of the instrument.
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e. they are investors), whereas bondholders have a creditor stake in the company (i.e. they are lenders). Being a creditor, bondholders have absolute priority and will be repaid before stockholders (who are owners) in the event of bankruptcy. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks are typically outstanding indefinitely. An exception is an irredeemable bond, such as CONSOL’s, which is a perpetuity, i.e. bonds with no maturity.
What to know about bonds:
- Type- Bonds may be issued as either secured or unsecured. Secured bonds are backed by physical assets which revert to the bondholder if the company cannot honor its obligations. Unsecured are called debentures and are backed only by the faith and credit of the issuer; obviously more risky than secured bonds. If a company does claim bankruptcy, bondholders are given priority over stockholders to any recovered funds.
- Maturity date- which is the day on which the issuer pays back your loan in full. This date can range typically between 3 and 10 years. In exchange for lending the company funds, the bond pays out interest (the coupon rate). These interest payments are generally made on a semi-annual basis, annual, quarterly, or even monthly.
- Prices– Bond prices move inversely with prevailing interest rates.
- When interest rates go up, bonds with lower interest rates will trade at a discount because investors can now buy them at higher rates.
- When interest rates go down, bonds with higher interests will command a premium because they pay a better rate.
- Ff interest rates rise when you already own a bond, you may miss out on the opportunity to buy the same bond for a higher rate of return. Also, the price of the bond will fall. This shouldn’t affect you If you’re intending to hold the bond until maturity. The only drawback is you will be earning less interest until it matures.
- Risks– If a bond goes into default, investors may lose some or all of their principal. Although rare with investment-grade bonds, but it’s always a possibility.
- The Yield is the rate of return received from investing in the bond. It usually refers either to
- Current yield, or running yield, which is simply the annual interest payment divided by the current market price of the bond (often the clean price), or to
- Yield to maturity or redemption yield, which is a more useful measure of the return of the bond, taking into account the current market price, and the amount and timing of all remaining coupon payments and of the repayment due on maturity. It is equivalent to the internal rate of return of a bond.
Note- The stock market and bond market are inversely correlated; as one rises, the other falls.
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