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What is a bond?

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Jim SteelWhat is a bond?

by Jim Steel, CFA, CFP

A bond, also known as a fixed-income security, is a debt instrument used by organizations to raise capital. They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.

Think of a bond as the exact opposite of a mortgage. A mortgage is essentially a loan to an individual by a financial institution (counter-party) to buy a house or property. The lender assesses the individual’s creditworthiness, determines the interest rate and lends the money. The individual then repays the counter-party a combination of interest and principal until the loan is retired or paid off. 

The individual has a choice of lenders: banks, credit unions, trust or loan companies or private sources. Generally, the interest rate will reflect the risk or creditworthiness of the individual; an individual who has a high credit rating would likely have a lower interest rate because there is less risk that the individual will fail to honour their debt obligation.

With a bond, there is a role reversal. The individual is essentially the lender and assesses the creditworthiness of the bond issuer or counter-party (usually a government, financial institution or other corporation). The interest rate (or investor’s return) is determined based on the credit quality of the counter-party; the higher the credit rating, the lower the interest rate because there is less risk that the counter-party will fail to honour their debt obligation.

The individual receives a guaranteed fixed interest rate for the duration (or term) of the bond at regular intervals. The only difference is that instead of receiving a portion of the principal each year, the investor only receives the interest payments. The investor receives the entire invested principal only at the end of the term.

Like stocks, bonds trade on a public market and can be bought and sold any time. As interest rates change over time, bond prices will fluctuate in value. In fact, there is a direct inverse relationship between interest rates and bond prices: as interests rates fall, bond prices rise, and vice versa, as interest rates rise, bond prices fall.

Consider the following:  If you invested $10,000 in a bank-issued bond at 3% interest for a five-year term, you would receive a $10,000 bond certificate. This certificate guarantees that the issuer will repay you the $10,000  in five years and also pay you $300 in interest each year for five years. In the event interest rates drop to 2%, your bond would increase in value because new buyers would be willing to pay a premium to receive the 3% interest that your bond is obligated to pay.  You could sell this bond to a new buyer in the public market and receive a capital gain over and above what you paid for the bond initially. You could therefore make more than the 3% interest you were initially guaranteed.

The opposite is also true. If interest rates were to rise, you would see the value of your bond drop. If you sold your bond in the public market, you would receive a capital loss and earn less than the 3%  initially guaranteed.

Or you could simply hold the bond until it matures, receive your 3% interest each year and get your $10,000 back from the issuer when the bond matures.

A final thought. The investor should examine the creditworthiness of the issuer. If the issuer goes bankrupt, there is no guarantee the investor will get their money back. For this reason, it is wise to invest only in bonds of the highest credit quality. We will explore the role of determining creditworthiness another day.

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