Bonds

Purchasing the bonds of a company is like giving that company a loan.  The same is true for buying government bonds (also known as Treasury securities), municipal bonds (towns, states, etc.), agency bonds (FLMC, GNMA, etc.) and many others.

Since most bonds behave in basically the same fashion we will refer to corporate bonds here, but the same concepts can be applied to many other types.

Essentially you are giving the company the use of your money for a set period of time and for that service they are going to pay you a set interest rate (or coupon payment).  The interest rate is often known as a coupon payment because before the whole world was electronic you would get a paper copy of the contract as your bond, and on the bottom of the contract paper were tear-off "coupons" that were redeemable for the interest payable on that bond.

Interest Payments

The interest payment and other terms of the bond are a contractual obligation for the company issuing the bond.  If they cannot repay the principal or miss a payment of interest, they go into bankruptcy.  This makes bonds a more stable investment than stocks, but they are not always 100% safe.  Some companies are a better risk than others.  There are companies out there called Rating Agencies (the most well known and respected are Standard & Poor's and Moody's) that rate the ability of a company to pay back its debts.  The companies that are best able to meet these obligations are given high ratings ('AAA' is the highest rating by Standard & Poor's) and those that have more trouble are rated on a declining scale (down to 'D' by S&P if an institution is in default).

Based on the factors that affect these ratings, and the perceived risk of an issuer is how a company will set the interest rate it pays on a specific bond.  You may have two companies that offer bonds that are identical in terms except for who they are and the bonds may offer very different rates.  The bond from the more stable issuer (say 'AAA') will have a lower coupon than the bond sold by an issuer with less stable credit (say 'BB').

Bond Pricing

Bonds, like stocks, may also provide a return to their investor in the form of a capital appreciation, or change in price.  But how can a bond change in price if everything is set in a contract??

The price of the bond changes only when it is traded in the open market.  If you buy a bond at par (which is typically an offering price of $1,000 per bond) and hold the bond until maturity (the end of its term) then you will be paid back your original $1,000 investment plus all the coupon payments along the way (considering, of course, that the issuer does not default).  However, if you prefer, you can sell that bond prior to its maturity date.  This is where a price change will affect that bond.

For illustrative purposes let us say that you hold a 5-Year term, AA-rated bond paying 5.00% interest.  You bought this bond from the issuer for $1,000 and receive $25 every six months (5.00% of $1,000 is $50, but it is paid semi-annually, so you get $25 every six months).  But now another AA-rated issuer comes out with a bond of 5-Year term paying 6.00% interest.  Now people aren't going to want your bond that only pays $50 a year, they instead want the other bond paying $60 a year with the same risk (remember they are both AA and 5-Year).  So if you want to be able to sell your bond under these conditions you will have to sell it for less than the original $1,000 you paid.  That is only if you go to sell the bond in the market, you could instead hold onto it for the remainder of the 5-Year term and receive your $1,000 back from the company.  But do you want to be receiving only 5.00% for that time period instead of the 6.00%?  That all depends on the given situation.

If you would like to know more about this and how bonds work check back again soon for more info!