Fast Finance: Understanding Bonds

Recently, there’s been a growing interest in what are known as “green bonds” in the impact investing world. Explaining green bonds is for another day, but I wanted to start by quickly explain the difference between stocks and bonds.

When it comes to investing, you can be either an owner or a lender. If you own stock (or shares of a mutual fund that invests in stocks), you are a shareholder and literally own part of a company. The company has no obligation to pay you back by redeeming your shares (although, sometimes a company chooses to buy back some of its outstanding shares), and the value of your shares will rise (or fall) with the fluctuations of the market.

On the other hand, when you buy bonds, you are acting like a bank. That is, you are lending your money to an entity (e.g., a company, state, municipality, or the U.S. government) for its promise to paywhich takes the form of periodic interest and a return of your principal (assuming you hold the bond to maturity and there has been no default). Barring default, the company does have an obligation to you as a bondholder to return the borrowed money. 

Here are some key terms for understanding the world of bonds:

Coupon: The stated interest rate on a bond the issuer promises to pay until maturity, expressed as an annual percentage of face value (amount repaid at maturity). For example, a bond with a face value of $1,000 paying 5% interest is said to have a 5% coupon. No matter what happens to the price of the bond, it will pay $50 in interest annually (5% x $1,000).

Current Yield: The coupon rate divided by the bond’s current price. Between issue and maturity, a bond’s price may rise or fall with changes in interest rates (among other factors). While the coupon rate always stays the same, the current yield could be more or less than the stated coupon depending on the current price of the bond. For example, a bond with a 5% coupon whose current price has fallen to $500 from its face value of $1,000 will have a current yield of 10%—that is $50 of interest based on a current price of $500 generates a 10% current yield (50 ÷ 500).

Yield to Maturity: The rate of return on a bond that is held to maturity, factoring in the purchase price, the redemption value, the coupon rate, the time between interest payments, and the time remaining until maturity.

Basis Point: The smallest measure used in quoting yields on bonds. One basis point equals one one-hundredth of a percent—that is, 100 basis points equals 1%. For example, if a bond’s current yield has changed from 8% to 7.25%, it is said to have fallen 75 basis points.

ParThe nominal or face value of a bond. A bond selling at par is worth the same dollar amount as it was at issue, and for which it will be redeemed at maturity. Bonds are typically issued with a $1,000 face (par) value.

Debenture (Unsecured) BondsBonds backed by the full faith and credit of the issuer, but not secured with any collateral. By comparison, secured bonds are backed by a pledge of collateral.

Bearer vs. Registered BondsBearer bonds are issued with detachable coupons that must be presented for periodic interest payment. Since coupons do not require endorsement, losing bond coupons is just like losing cash. Gradually, bearer bonds have given way to registered bonds, which are recorded on the books of the issuer (or issuer’s registrar) in the name of the bondholder. Registered bonds can be transferred to another owner (e.g., by sale or gift) only by endorsement of the registered owner. 

ABOUT THE AUTHOR

Kevin Lum

Kevin Lum

Kevin is the founder and CEO of Foundry Financial

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