What are bonds?
Bonds are debt securities issued by corporations, governments and municipalities. Bonds are similar to IOUs: investors lend money to an organization and in return receive interest payments. In addition, the organization is obligated to return the principal to investors on a predetermined date in the future. When purchasing bonds, investors become creditors of the issuer and, therefore, have a priority claim on the issuer’s assets in the event of bankruptcy.
Par or face value is the bond’s denomination and the amount returned to the investor upon maturity. Par is not the price of a bond, as the price fluctuates throughout the lifetime of a bond. If the price is above par, the bond is selling at a premium, and if the price is below par, the bond is selling at a discount. Price is generally quoted as a percentage of face value. For example, a price of 98 means 98% of the bond’s $1,000 par value, or $980.
Coupon rate (or just coupon) is the annual interest rate paid to investors as compensation for the loan. Coupon payments typically are made semiannually unless otherwise stated. For example, a 4% coupon bond will pay 2% twice a year based on the par value of the bond. Learn more about types of income.
Maturity is the term of the bond’s life. Bonds range in maturity from three months to 100 years. On the maturity date, the bond’s face value is repaid to the investor and the interest payments stop.
Call provisions give an issuer the option, at its discretion, to redeem bonds (pay back the principal) prior to maturity after an initial non-call period. Bonds are generally called when the situation is most beneficial for the issuer. In general, bonds are called when market interest rates fall, allowing the company to issue new bonds with lower coupon rates. To compensate investors for the reinvestment risk and unknown final term of investment, callable bonds generally offer higher yields than non-callable alternatives. Learn more about callable bonds.
Credit rating is usually a reflection of an issuer’s ability to pay interest and principal but may not fully represent its creditworthiness. Independent rating agencies assign ratings based on their analysis of the issuer’s financial condition, economic and debt characteristics, and specific revenue sources securing the bond. Issuers with lower credit ratings generally offer investors higher yields to compensate for the additional credit risk. At times, bonds with comparable ratings may trade at different yields, which may further indicate the market’s perception of risk. A change in either the issuer’s credit rating or the market’s perception of the issuer’s business prospects will affect the value of its outstanding securities. Ratings are not a recommendation to buy, sell or hold, and may be subject to review, revision, suspension or reduction, and may be withdrawn at any time. More details about credit ratings can be found at Factors That Affect Prices of Fixed Income Securities.
Yield is the annual rate of return investors earn based on a bond’s coupon rate relative to its current market price. When interest rates rise, the price of an existing bond falls because its coupon becomes less attractive to potential investors. The opposite happens when interest rates fall. Hence, there’s an inverse relationship between a bond’s price and its yield. Bond yields should be evaluated on a worst-case-scenario basis. The two most frequently referenced yields.
- Yield-to-maturity (YTM) is especially important when bonds are purchased at a discount. Investors should compare YTM to the current yield of comparable new-issue bonds to make sure the discount is big enough to result in the same return or higher. Generally, YTM for a new-issue security is equal to its coupon rate.
- Yield-to-call (YTC), or yield-to-worst case (YWC), must be considered when a bond has call features and is purchased at a premium. An issuer is more likely to call a bond prior to maturity when interest rates decline, giving the company an opportunity to offer new bonds at lower rates. The prices of callable bonds will not rise as much as those of non-callable securities because investors are not willing to pay more due to the increased chance of a call.