What Are Bonds?

A bond is a type of loan that you, as an investor, give to a company or government. In return, they promise to pay you regular interest (called the coupon rate) and repay the full loan amount (called the par value) at a set future date (called the maturity date). 

Unlike stocks, where you own part of a company, a bond simply means you are lending money to the issuer. Bonds are generally considered safer than stocks because, in case of financial trouble, bondholders are paid before stockholders. However, some bonds can be riskier depending on the issuer's credit rating.

Types of Bonds

Fixed income, most commonly associated with bonds, is one of the big asset classes. While the stock market might capture more public attention, the fixed income market is actually larger in scale. However, it remains a relatively unfamiliar territory for those outside the financial industry.

Bonds are primarily categorized as either government bonds or corporate bonds. Government bonds are issued by national governments, while corporate bonds come from companies seeking to raise capital. There are other types of bonds as well, such as municipal bonds, which are tied to local government entities like cities, states, or counties.

At its core, a bond represents a debt security. When an investor purchases a bond, they are essentially loaning money to the issuer, be it a government or a corporation. In return, the bondholder receives periodic interest payments, making bonds different from equities, which represent ownership stakes. In short, equity is ownership, whereas a bond is a loan.

Features of a Bond

When dealing with bonds, several terms to understand:

Maturity Date: Bonds come with a specified maturity date, which is when the principal, or the original loaned amount, must be repaid. Maturity periods can range from short-term bonds like 1-year bonds to longer terms such as 10-year or 30-year bonds.

In the case of US government bonds, which are commonly referred to as US Treasuries, different maturity dates are known by specific names:

Treasury Bills (T-bills): Maturity of one year or less.

Treasury Notes (T-notes): Maturity between two and ten years.

Treasury Bonds (T-bonds): Maturity between ten and thirty years.

Other countries use different terminology for their government bonds. For example, UK bonds are often called Gilts.

Coupon Rate: This is the interest rate paid by the bond issuer to the bondholder, often referred to as the yield. The yield indicates how much income the investor can expect to receive over the life of the bond.

Par Value: Also known as the face value, this is the amount that will be repaid to the bondholder at maturity. While this is typically the price at which the bond was issued, market fluctuations can cause the current price to differ from the par value.

The Price-Yield Relationship

Bond prices and bond yields have an inverse relationship. When yields increase, bond prices fall, and when yields decrease, bond prices rise. This dynamic impacts the value of bonds held by investors.

Bond Grades

Bonds are generally considered a safer investment compared to equities, largely due to something called seniority. In the event of bankruptcy, bondholders have a higher claim on the company’s assets than equity holders, meaning they are paid first. However, not all bonds carry the same level of risk.

To assess a bond’s risk, investors rely on credit ratings issued by agencies such as Moody's or Standard & Poor’s. Bonds are classified into two broad categories:

• Investment-Grade Bonds: Bonds with a relatively low risk of default, given higher credit ratings.
  
  
• Non-Investment Grade Bonds (also known as junk bonds or high-yield bonds): These come with a lower credit rating and therefore offer higher yields to compensate for the increased risk.

The credit rating system typically uses letters, with AAA being the highest rating, denoting strong creditworthiness, and lower grades reflecting greater risk. The rating agencies also provide an outlook for the bond issuer, indicating expectations for future financial health.

Trading Bonds

Bonds play a big role in large investment portfolios, especially in pension funds, which seek relatively safe investments that provide a steady income stream. Due to their lower risk profile and consistent income generation, bonds are a natural fit for long-term investment strategies.

Though less popular among retail investors, bonds are actively traded in massive markets worldwide. Retail traders may find bonds somewhat inaccessible compared to equities, but professional traders, especially those dealing with futures, regularly engage in bond markets. 

For example, traders may focus on German Bunds during European trading sessions or US Treasuries, particularly the 10-year Treasury note, during the US trading hours. The 10-year Treasury is especially important, as it has the highest daily trading volume in the US bond market.