Bond Basics

Feb 18, 2019

Bonds are a form of debt. And debt has a bad reputation since it’s associated with regret, compounding credit payments, and the sea of college grads that are struggling to chip away at their loans from Sallie Mae.

But without debt, most of us wouldn’t be able to afford a car or home. Businesses use debt to fund operations and grow without giving up ownership. The Federal Reserve is able to keep inflation at bay by issuing or purchasing bonds.

Side Note: This guide was supposed to be a part of my post on Why I Made a Bond Portfolio Analytics App, but I decided to tease it out into its own post.

What is a Bond

A bond represents a loan made by a lender (the investor) to a borrower (the bond issuer) in which:

  • the lender agrees to loan the borrower funds for a specific period of time
  • the borrower agrees to repay the loan in full and any interest incurred

    • the borrower pays interest on the bond to compensate the lender for using their money

List of common bond characteristics:

  • Par / Face Value — the amount of the loan
  • Coupon — the interest payment
  • Price — the amount a buyer would pay to receive all future cashflows (par and coupons) from the bond
  • Yield — the lender’s realized return
  • Maturity Date — date in which the loan is repaid in full
  • Issuer — the borrower
  • Credit Risk — the chance the bond issuer won’t be able to pay back the lender

Bond Issuers

Bonds can be issued by all types of institution including governments, banks, and corporations.

Why issue bonds?

Local governments issue bonds to finance public projects, like a highway or school, and usually pay back the bonds through taxes or fees generated from the project.

Financial institutions, including large banks, can issue bonds as a way to raise funds used for lending.

Corporations issue bonds to raise money without diluting shareholder’s equity. By issuing bonds, a corporation can usually borrow at a lower rate and longer term relative to loans available at a bank.

Credit Ratings

A bond’s credit rating measures the likelihood that the bond issuer will pay back the loan. A high credit rating indicates a lower chance of default.

Bond issuers are given a credit rating by rating agencies. The top three rating agencies are Standard & Poor’s, Moody’s, and Fitch. The highest investment grade bond is a triple AAA rated bond. Whereas junk bonds are given a C or D grade. Generally, rating agencies use different combinations of letters to grade bonds. For example, Microsoft’s corporate credit rating is AAA by Standard & Poor’s and Aaa by Moody’s.

Maturity Range

A bond’s term to maturity can range from 1 day to 100 years, but bonds are typically issued under 30 years. Bonds are usually grouped into three categories depending on their maturity range:

  • short-term bonds — less than 3 years
  • intermediate-term bonds — 3 to 10 years
  • long-term bonds — over 10 years

Interest Rate Risk

Interest rate risk is the chance bond prices will decrease due to the rise in interest rates.

Bonds with longer terms tend to yield a higher return because investors need to be compensated for taking on increased interest rate risk and greater exposure to potential default.

Inverse Relationship of Bond Prices and Interest Rates

Bond prices are a function of the characteristics listed above and the “risk-free” interest rate.

In theory, the risk-free rate is the minimum return an investor expects from a risk-free investment. U.S. Treasury bills are commonly used as a proxy for the risk-free rate since the U.S. has never defaulted, and the U.S. dollar is widely considered the world’s strongest currency. However, what you consider a risk-free investment is really up to you.

An investor uses the interest rate paid on a T-Bill as a benchmark against all other investments since they can earn X% return on a T-Bill with little to no short-term risk. In turn, when the risk-free rate is lower, investors are willing to settle for lower returns on investment.

Bond prices are inversely correlated with interest rates because a bond’s par and coupon payments are fixed and a rise in interest rates would make the bond’s future cash flows less attractive.

For example, let’s say you buy a 6-month T-Bill yielding 2% for $1000. If T-Bill interest rates rise to 3% the next day, then nobody is going to buy your T-Bill at $1000 yielding 2% when they can get 3% on the market. To get investors to buy your T-Bill, you would need to lower its price such that it yields at least 3%.

Thus, the inverse rules are:

  • lower interest rates => higher bond prices
  • higher interest rates => lower bond prices

Well, that’s it, a short overview of bonds as promised. Bonds don’t come up in conversation too much unless you’re involved in the industry or talking to an advisor, but bonds are a vital part of the economy and a topic worth learning more about!