In finance, a bond is a contract between a business which needs money (e.g. to fund their growth) and an investor who wants to receive an income stream plus their cash back in time. In the good ol’ days, a bond would be written on a piece of paper.
Tip: A bond is a debt owed by a company to an investor (called a ‘bondholder’).
A bond is very similar to the way a bank lends money on a mortgage, except there is one very important difference: the principal is repaid at the end of the contract in a lump sum.
How does a bond work?
A bond is a promise, usually by a business or company, to return an amount of money (e.g. $100) at the end of a period of time. Many bonds also make a series of payments back to bondholders (the investors who ‘hold’ the bonds). This is called a ‘coupon’.
Already, you’re probably starting to see that what makes bonds so confusing is the language we use to describe them.
Here are some of the key terms:
- Bondholder: the investor who receives the income and the final cash back
- Maturity: when the ‘face value’ (see below) of a bond is due to be repaid.
- Face value: this is the amount a bondholder receives when the bond hits its maturity date (e.g. ‘$100 in 10 years)
- Coupon: think of these things like dividends from shares, except it is commonly set in advance (e.g. $5 per $100 bond). These are often paid six-monthly or yearly.
- Bond price: the price of a bond in the market today.
If a bond without coupons will be bought back by a company for $100 in 10 years, the current pricemust be less than $100. Why? Well, an investor would demand a return for owning that bond for so long.
So, for example, if they could buy the bond today for $70 and hold it for 10 years until it matures it means they will make $30 in profit over 10 years. - Yield: this is a yearly percentage (%). It’s the ‘expected return’ for owning a bond from now until it matures. Remember how the bond price (see above) doesn’t always equal $100? Remember how some bonds pay coupons (kind of like dividends)? Well, yield or “yield to maturity (YTM)” is an interest rate percentage which estimates the yearly return from holding a bond. (for math nerds like us, it’s the Internal Rate of Return or IRR).
What does the yield equal?
If you total up all of the expected coupons and the final ‘face value’ (e.g. $100) of a bond, the yield is the interest rate which makes the future returns equal today’s bond price. However, the ‘yield to maturity’ assumes everything is paid on time (just imagine if the company who promised to repay the bond when bankrupt!).
If you made it through that section, well done!
What happens when interest rates change?
This is important: when interest rates change, the price of bonds will change.
Think about it like this: you are an investor with a bond that yields 5% but interest rates just went up to 10%. Your bond is now priced less than before. Why? Your bond yields only 5% but other bonds now yield 10%, so other investors would sell your bonds to buy the other bonds (pushing down the price of your bonds).
It works the same the other way. If interest rates fall to 2%, your 5% bonds are worth more – hooray for you!
However, even if the bond’s price jumps all over the place you should still receive the coupons and face value that were set in the original bond contract.
Why do companies issue bonds?
Companies issue bonds to raise capital for their investments or to pay off their other debts.
The bond market is a huge one, the Bank of International Settlements (BIS) believed the global bond market was valued at $US92 trillion in 2017. As for shares? The World Federation of Exchanges placed their value at $US70 trillion.
Differences between bonds and shares
Shares represent part ownership of the equity in a business. Equity is what’s left over after you value the assets of a business (buildings, cash, machinery, etc.) and take away the liabilities (like debt, money owed to suppliers, etc.).
This video explains more:
Bonds are a form of debt, which means if a company goes bankrupt the bondholders will get their money before the shareholders. It’s the same as if you defaulted on a mortgage — the bank gets its money before you do.
For example, a company goes bankrupt and has $100 million left over after paying its suppliers. It has $80 million of bonds. The bondholders will get paid their $80 million, then the shareholders will get what’s left over ($20 million).
Bonds are often said to be ‘safer’ than shares. However, some bonds (esp. those called ‘junk bonds‘) are issued by very risky companies and businesses. Therefore, although junk bonds pay higher coupons they could go bankrupt before you receive your money!
Share prices can often rise substantially faster than bonds, given the risk.
How have bonds performed over time versus shares?
Click here to go to Vanguard Australia’s interactive chart which compares shares, bonds and property over very long periods of time.
How can I buy Bonds?
In the past, direct bond investors usually had to have millions of dollars to invest, so owning bonds directly was often out of reach for many do-it-yourself (DIY) investors.
However, many managed funds and exchange-traded funds (ETFs) often invest in bonds.
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