What is a bond?

Think of bonds the same way you would when buying a house.  House bonds typically serve as an IOU for homeowners to pay back a loan to the bond issuer, in this case, the bank.

Similarly, in finance, bonds are investment securities representing a loan made by an investor to a borrower, typically corporate or governmental.  Instead of going to the bank, the bond issuer enters a legal agreement to pay investors interest and agrees to reimburse the original sum loaned at the bond’s maturity date.

Since your investment earns fixed payments over the bond’s lifespan, “fixed income” is often used to describe bonds.  The bond market is also known as the credit or debt market.

Though bonds are generally issued in multiples of $1,000, the bond’s price is subject to market conditions and often fluctuates below or above par value.

To better understand bonds, there are a few key terms to remember:

Bond Maturity: The bond’s maturity date represents its lifespan, whereby the owner will receive interest payments on the investment.  Most bonds have a specific maturity date and are usually set when issued.

Coupon: The coupon amount represents the interest paid to investors or bondholders and typically won’t change.  Rarely used nowadays, coupons used to be physical attachments to paper bond certificates, with each coupon representing an interest payment.

Yield: Bond yield is a measure of return.  Whereas coupon is fixed, the yield varies and depends on a bond’s price in the secondary market and other factors.

Duration Risk:  Bond duration measures how much bond prices are likely to change if and when interest rates move. The longer the bond’s duration, the higher the exposure to price changes in interest rates.

Face Value: A bond’s face value indicates what your bond will be worth by the time it reaches maturity, most commonly a par value of $1,000.  It is also the basis for calculating the interest payments.

Rating: Bond ratings measure the credit worthiness of a bond assigned by rating agencies. Independent services like Standard & Poor’s evaluate a bond issuer’s financial strength or ability to pay the bond and interest promptly, helping investors understand the risk of investing in bonds.

The difference between a bond and a stock

Unlike stocks, bonds issued by companies give no ownership rights to bondholders, which means they do not profit from the company’s growth.

The stock market also has central places or exchanges where stocks are bought and sold, whereas most bonds aren’t traded publicly and can only be purchased over the counter (OTC), meaning you must use a broker.

Albeit nominal, the bond market provides investors with a steady and regular source of income.  On the other hand, return on stock investments fluctuates, which further separates the two instruments in terms of the risk involved when investing in each.

Investors who trade stocks are subject to risks like currency risk, liquidity, and sometimes interest rate risks, while the bonds market is more susceptible to inflation and interest rate hikes.

Consensus

As you get closer to retirement, market downturns may set you back if you made the mistake of dumping all your investment in stocks.

Thus, bonds will play an essential role in your portfolio and working with a broker will help you navigate fixed-income investing and diversify your assets with a long-term approach.