A bond is a debt security in which the authorized issuer owes the holders a debt and, depending on the terms, pays interest to use. A bond is simply an I.O.U. between the lender and the borrower detailing what has been borrowed, repayment dates, when funds are due back to lenders, etc. Companies, municipalities, states, and sovereign governments use bonds to finance projects and operations. Bondholders are creditors of the issuer. As of year-end 2023, the aggregate value of U.S. Treasury bonds on issue exceeded $31.4 trillion, indicating their importance in global financial markets, for example.
Basic characteristics of bonds
Bonds have some basic qualities of face value, coupon rate or interest payment, maturity date, and issue price. A bond has a face value, which is the amount paid to the bondholder at maturity and is usually $1,000 per bond. A bond with a 5% coupon rate has an interest or annual payment of $50 that the issuer pays out to its investors every year. The face value is the amount that investors receive at maturity when the bond expires and they are paid by their issuer. A 10-year U.S. Treasury bond was yielding approximately 3.5% in 2023, and this represented the market expectation for future long-term returns for debt instruments. The price at which the bond was initially sold is called an issue price, and it can be either above or below face value. A good example could be a bond issued for $980 and paying $1,000 at maturity.
Types of Bonds
There are different types of bonds: government, corporate, municipal, and zero-coupon. For example, sought-after government bonds, in 2023, Japanese government bond supply topped $10 trillion. Companies issue corporate bonds, an example of this would be when Apple Inc. issued corporate bonds in 2022 to purchase $14 billion worth of its own shares as well as pay dividends. The state or local governments also issue bonds to fund large projects; for example, New York City issued $3 billion in municipal general obligation bonds in 2021 to support infrastructure programs. Zero-coupon bonds do not pay regular interest but are sold at a discount to face value and repaid at face value upon maturity (e.g., a 5-year $800 bond will be given back as $1,000 in five years).
Bond returns and risks
Bondholders realize returns largely based on regular interest payments and the repayment of principal at maturity. For instance, if you owned 5% corporate bonds with a face value of $100,000, then your interest would be $5,000 per year. Sometimes the rise in prices at secondaries induces capital gains; for instance, a bond with a $1,000 nominal value can ascend to $1,050 if the market interest rate decreases, and thus the investor sells it with this notional take-profit. The biggest dangers associated with bonds come from credit risk, interest rate risk, and inflation risk. For the issuer, this is known as credit risk (in 2020, for instance, Argentina defaulted on its bonds and it cost bondholders a fortune). Interest rate risk occurs when bond prices plummet due to an increase in market interest rates, and when the Federal Reserve raised rates in 2022, many long-term bonds fell significantly. The risk that most people think of in this context is inflation risk; if a bond pays 3% annually and inflation averages 4%, the real return would be -1%.
The role of the bond market
The bond market is important to the financial system. By 2023, the total bonds outstanding in the world reached over $120 trillion, representing roughly one-half of all other financial market assets. It allows both governments and corporations to raise money with a relatively secure investment product. The bond market also affects overall interest rates in the economy and the credit environment; for example, the Federal Reserve uses bond purchases and sales to influence market interest rates and achieve its monetary policy goals.
Strategies for investing in bonds
Bond investment strategies include diversification, credit analysis, and duration management. Diversification refers to spreading out your bond investment across different types of bonds and maturities to reduce risk; for example, a portfolio might be composed of 50% government bonds, 30% corporate bonds, and 20% municipal bonds. Credit analysis is part of choosing among bonds by examining an issuer’s capacity to pay back its loan obligations; typically, only higher-rated bonds like those rated AAA or equivalent should be considered “safe” investments. Duration management is the practice of adjusting bond maturities in a portfolio based on interest rate outlooks (e.g., choosing short-term bonds when an increase in interest rates is likely to decrease price risk and long-term bonds if expecting falling interest rates).
