A bond is a loan to a company or government for which you are the lender and the organization selling the bond is the issuer. Investopedia says: “You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).”
Bond-holders are paid interest at pre-determined rates and times for the privilege of lending out their money. Bonds are known as fixed-income securities for this reason; you know exactly how much you will get back from the date you loan the money until maturity.
What is the difference between bonds and stocks?
Bonds are debt; stocks are equity. A stock-holder becomes an owner in that business, with voting rights and a share of future profits, whereas buying bonds makes an investor a creditor to the company or government. The bond-holder does not share profits, but is repaid the principal lent plus interest; however, in case of bankruptcy they would be paid before shareholders. There is generally less risk in bonds than stocks, but a lower return.
A newly issued bond sells at the face value (par value) or principal, which is what the bond-holder will get back once the bond matures. However, this is NOT the price of the bond, which fluctuates. When a bond trades above face value, it is selling at a premium; when it sells below face value, it is selling at a discount.
Most bonds pay interest every six months, but it’s possible for them to pay monthly, quarterly or annually. The interest rate (or coupon) is expressed as a percentage of the face value. A rate that stays as a fixed percentage of the face value is a fixed-rate bond. A floating-rate bond has its interest rate tied to market rates through an index.
The maturity date is the date in the future on which the investor’s principal will be repaid. Maturities can range from one day to 30 years or more.
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. In general, the longer the time to maturity, the higher the interest rate.
Bond ratings are normally expressed as AAA-A (all investment grade), BAA/BBB (investment), BB, B, CCC-D and D (junk). Junk bonds are very high-yield because they are the debts of companies in financial difficulties, so are very risky.
Classified according to the length of time before maturity, rather than by risk (as they are lower risk): bills (mature in less than a year), notes (mature in one to 10 years), bonds (mature in more than 10 years). Countries can, of course, default on payments just as corporations do, particularly developing countries.
Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long-term is 12 years plus.
There is a higher risk of a company defaulting than a government and therefore a higher potential yield too. The higher the company’s credit quality or rating, the lower the interest rate.
Convertible bonds can be converted into stock and callable bonds can be redeemed or called back by the company before they mature.