Bond Basics - What is a bond?

In order to define a bond, one must understand a little about interest rates because that plays a key role for a bond. Interest rates are a very complex topic and subject to countless books explaining various interest rate phenomena, but at the heart of it, interest rates are very simple. Simply defined, the interest rate is a fee charged for lending someone money. If I loan you $1,000, you are expected to repay that $1,000 eventually. But also, I would tell you to pay me, e.g., $100 per year until you repay me the full $1,000. The $100 is essentially a fee for using my money. Also, that $100 can be expressed as a percentage which is the interest rate. In our example, the interest rate is 10%.

$100/$1,000 = 0.10.

So now we're ready to talk about bonds. A bond is a debt instrument which essentially represents a contract between you and someone else (usually a financial institution) where one party loans a specified amount of money to the second party in return for a fixed interest rate.

Lets break this down a bit. First of all, the term "debt instrument" is used to define the type of item being purchased. We call it a debt because it represents a liability for someone taking that money from you. Consider your own personal situation; when you can't afford something outright you go into debt in order to purchase it. A perfect example (and I'm sure you know by now) is your house. A house can be very expensive and who has that kind of cash lying around? So you borrow some amount of money from a financial institution; they give you the money to pay off the house builder; and you agree to make periodic payments to the financial institution (that payment represents a combination of the original amount loaned and the interest payment). Similarly, when corporations want to make huge purchases, they can't afford it outright (like building a new power plant) so they borrow the money from someone else.

The second concept to explain is the fixed interest rate. Again, taking your home as an example, you may be aware that the loan you take on is either a fixed rate loan or a adjustable rate loan. A fixed rate means the interest rate charged will never change for the life of the loan. In adjustable rate loans, the interest rate may change. Similarly with Bonds, the interest rate is fixed for the life of the bond (there always are exceptions, but generally that is correct).

So lets recap. So far we've covered the basics. A bond basically represents that somebody wants make a large purchase but can't afford it. So they go into debt by borrowing money. Also, the bond is set at a fixed interest rate. Now, lets cover some other basic characteristics of bonds.

Bond Characteristics

Lets cover each of the above points. The face value of the bond is sometimes also called the par value. It is literally the value stamped onto the bond certificate. It is the amount the borrower wants to borrow and also the amount you will get back at the end. You will also hear it termed the "principle" (not to be confused with your school principal who will send you to detention!). Again, in our house example, when you borrow the money from the financial institution, what do your payments represents? Yup, that's right...a combination of principle and interest. You are paying back the financial institution the original money you borrowed plus some interest. So the bond's $1,000 face value is also the principle amount.

Bonds are issued at varying terms or maturities, depending on the issuer's ability to repay and the amount of money borrowed. You may be able to pay back $1,000 in a year. But what if you borrowed $10,000,000? I think you'd need some time to repay that. If the bond has the characteristic of being "callable", it means whoever issued the bond has the right to recall the bond from you before it reaches maturity. What happens in that case is you keep the interest payments up until the recall date and then you get back the principle amount (i.e., the face value).

Bonds also pay a fixed dollar amount, instead of a percentage, based on the face value. This is an important distinction to make as it affects what is called the yield. Now imagine you buy a bond for $1,000 (which happens to be the face value) and it pays $50 per year. That's called a 5% yield. Or put another way, the interest rate you receive is 5%. What if the next day interest rates go up and you can buy new bonds (with all else being the same) also for $1,000 and which pay $60? So the yield on that 6%. Since both bonds are traded on the market, the market will adjust the price of the bonds such that the old bond will also yield 6%. How does that happen? Remember that the bond was paying $50 on the $1,000 face value which yielded 5%. The only way to get a 6% yield is if the price of the bond was different from the face value. So the price of the bond drops to approximately $825. But you still get the $50 interest payment. If you divide the two ($50/$825) you get approximately 6%. This is great news to some investors because they can buy the bond at a "discount" and remember that the principle amount they get back at the expiration is the face value. So that's a double bonus!

At this point, you may be asking why have the price of the bond different from the face value? Well, the example I gave you is one reason. Bonds need a way of adjusting themselves when being traded. Another reason is the issuer of the bond needs to borrow a set amount of money. It would be quite confusing if the issuer wanted to borrow $10,000,000 to build a power plant but only received $8,000,000 because the market decided otherwise. That introduces the concept of the primary and secondary market for bonds which is explained in our next section, trading bonds

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