Bond

A bond is a debt security. The Securities and Exchange Commission's investor education puts it as plainly as it can be put: "A bond is a debt security, like an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time." Four words describe the whole arrangement. The issuer is the borrower. The principal, also called the face value or par value, is the amount repaid at the end. Maturity is the date that repayment is due. Interest is what the issuer pays for the use of the money along the way, commonly twice a year. Nothing in the arrangement makes you a part-owner of the issuer, and nothing entitles you to more than the amounts promised.

One point of confusion is worth clearing immediately, because the word does double duty in finance. A surety bond, performance bond, fidelity bond or bail bond is not a debt security and is not an investment at all. Those are guarantees that some person or business will meet an obligation, purchased the way insurance is purchased. When an executor is required to post a bond, or a contractor is bonded, that is the guarantee sense of the word rather than anything described on this page.

The single fact that organizes everything else is that a bondholder is a creditor. A stockholder holds a residual claim and is paid only after everyone the company owes has been settled with; a bondholder is one of the parties being settled with first. So the two instruments sit on opposite sides of the same sentence, and the ranking explains their behavior in both directions. Because the payments are promised, they are steadier and the investment is ordinarily less volatile. Because the payments are only what was promised, an issuer that triples in value owes its bondholders exactly the same interest it always did. Bonds are not the safe version of stocks; they are a different bargain, in which a capped return is exchanged for a senior claim.

The mechanic that surprises people is that a bond's market value changes after you buy it, and moves opposite to interest rates. If comparable new bonds start paying more than yours does, nobody will pay full price for yours, so its price falls until the deal is competitive again. If new bonds pay less, yours becomes worth more. A holder who keeps the bond to maturity collects the promised interest and principal regardless, so the price change matters only on a sale. This is also where a bond fund behaves unlike a bond, which is the distinction most often missed. An individual bond has a maturity date and repays a known amount on it, so an owner can wait out a price decline. A fund is a continuously managed pool with no maturity date, so its share price simply reflects what its holdings are currently worth, and a shareholder has nothing to wait for. A fund of high-quality bonds can post a real loss in a year when no issuer it holds missed a single payment.

Who is borrowing is the other axis, and the SEC groups issuers three ways. U.S. Treasury securities are obligations of the federal government, issued as bills, notes, bonds and inflation-protected securities. Treasury also sells savings bonds directly to individuals, including Series EE and the Series I savings bond, whose rate is reset twice a year from a fixed component and an inflation component; unlike the securities above, these are not traded, so you buy them from and redeem them with the government. Municipal bonds are issued by states, cities and their authorities, and are usually distinguished by whether a general taxing power or a specific revenue stream stands behind them. Corporate bonds are issued by companies. Cutting across all three is credit quality: rating agencies grade issuers, and the market divides them broadly into investment grade and high yield, the latter still widely called junk. A higher stated interest rate on a lower-graded issuer is compensation for a greater chance of not being paid, not a better deal that somebody overlooked.

The SEC names five risks a bond investor carries, and each is worth recognizing by name because they are not variations of one thing. Credit risk is the issuer defaulting. Interest rate risk is the price effect above. Inflation risk is that a fixed payment buys less over time, which is a real cost on a long bond even if every payment arrives. Liquidity risk is difficulty finding a buyer at a fair price. Call risk is the issuer repaying early when rates fall, handing back your money precisely when you can no longer replace the income.

An issuer sells a bond at issue, receives the money, and takes on two obligations: to pay interest on a schedule, and to repay the principal at maturity. The investor's return comes from those payments, plus or minus any difference between what the bond was bought for and what it is eventually sold or redeemed for. If the issuer meets its obligations and the investor holds to maturity, the result is known in advance, which is the feature no stock offers.

A hypothetical example. Devi buys a bond at its $10,000 face value with a 10-year maturity, paying 4% a year in two installments. She receives $200 every six months, so $400 a year, and over the full ten years $4,000 of interest plus her $10,000 principal back at maturity.

Now suppose that two years in, comparable new bonds are being issued at 5%. A buyer choosing between Devi's bond, which pays $400 a year, and a new one of the same quality and remaining term paying $500, will not pay $10,000 for hers. Its market price falls until the two offers are competitive. Devi's income has not changed and her $10,000 at maturity has not changed, so if she holds the bond the price move costs her nothing; if she needs to sell it that year, she takes a real loss. Had new bonds instead been issued at 3%, hers would be the more attractive contract and would sell above face value. How large the price move is, and how it is expressed as a yield, is a separate calculation.

Pros

• The payments and the repayment date are contractual, so the outcome of holding a bond to maturity is knowable at the time of purchase in a way a stock's outcome never is.
• A senior claim. Bondholders are paid ahead of preferred and common stockholders if the issuer is liquidated.
• Interest arrives as cash on a schedule without selling anything, which is useful for spending that is already dated.
• High-quality bonds have often held their value when stock prices fell, which is what makes them useful as ballast rather than merely a weaker stock.

Cons

• The upside is capped by contract. An issuer whose business thrives owes its bondholders nothing more.
• Rising interest rates reduce the market value of bonds already held, and a bond fund gives its shareholders no maturity date to wait for.
• A fixed payment loses purchasing power to inflation, and the longer the bond, the more of that risk it carries.
• Credit risk is real and is priced. A higher interest rate on a lower-graded issuer is compensation for a greater chance of not being paid.
• Individual bonds can be harder to buy, sell and price than listed shares, and the cost of trading one is usually built into the price rather than charged separately, which makes it less obvious than a stated fee.