What is a bond?
A bond is a loan which specifies interest rate, maturity date, and interest payment dates. The Federal government issues bonds to fund capital projects and spending exceeding tax receipts. Cities and towns often issue bonds to raise funds for infrastructure repairs, new schools, or new fire trucks. Businesses issue bonds to finance accounts receivable, hire more employees, update equipment, or to research and develop new products. Individuals and institutions can purchase bonds to help the borrowers bankroll these projects and trade the bonds to update their portfolios. Bond investments are generally considered “safe”.
The world of bonds has its own vocabulary. For instance, convexity does involve curves, but not the ones in magnifying glasses. And, the opposite of convexity is not concavity, but negative convexity. We’ve pulled together this handy glossary to clarify the terminology surrounding bonds.
- Bond categories:
- Corporate bonds represent company borrowing.
- Municipal bonds can be borrowing by states, state authorities (water departments, hospitals, universities), and cities and towns.
- Government bonds are US government borrowing – the U.S. Treasury issues these.
- Agency bonds come from groups affiliated with the government like Fannie Mae or Freddie Mac.
- Foreign bonds are borrowing by non-U.S. entities including countries, businesses, and municipalities.
- Bond types:
- Zero-coupon: these pay no interest. Issuers sell them at a discount to face value which is paid at maturity. Larger discounts mean higher (implicit) interest rates.
- Convertible: bondholders accept lower interest rates in exchange for the option to convert from bonds to stocks. This can be advantageous for the issuer (who pays lower interest rates and does not have to pay back the principal). Bondholders may benefit if the stock appreciates – the principal payment may be large.
- Callable: the bond issuer can call back these bonds prior to the maturity date, pay the bondholders their principal, and reissue bonds at a lower interest rate. This may happen if the issuer’s credit rating improves, or interest rates fall.
- Puttable: these bonds allow the bondholder to sell the bond back to the issuer prior to maturity. Bondholders may avoid a decrease in the bond’s value if interest rates rise.
- Issue price: amount the bond issuer sells the bond for
- Face value: value of the bond at maturity
- Maturity date: date issuer returns bondholder’s principal
- Coupon date: date each year when issuer pays interest
- Coupon rate: rate of interest issuer pays bondholder
- Investment grade: bonds issued by entities with high credit ratings like the government or some corporations. These bonds have a low risk of default.
- High-yield: companies offering these bonds have lower credit ratings, but are still solvent. The bondholders take more risk, so their interest rates are higher.
- Convexity: how much duration changes as interest rates change. In general, bonds with low coupons have higher convexity, and vice versa.
- Duration: how much interest rates affect a bond’s price (also, the weighted average arrival date of a bond’s cash flows).
- Principal: the amount the issuer borrows from the lender.
- Interest: the amount the borrower pays for the use of bondholder’s money.
- Yield-to-maturity: the average return of a bond when the buyer holds it until its maturity date.
- Internal rate of return: the anticipated rate of growth of a given bond.
- Par value: face value of a bond, usually $1,000.
We hope you find this helpful. Please contact your financial advisor for more information.
Do you like glossaries? Here’s another on estate planning terminology.