Lending is the economic basis of every civilization. People lend to each other informally until their business dealings and economic activities become more complex; then the systems supporting lending evolve and become more complex and formal too.
Modern day lending practices, banking systems and legal agreements have provided the structure for creating bonds. This type of lending has become a sophisticated market in its own right - $42 trillion in bonds are now issued in the U.S., and $106 trillion in bonds have been issued worldwide, according to SIFMA.
How Bond Markets Developed
Bonds were first issued in 14th century Venice when city residents were forced to lend money to the state to finance a war with Turkey.
When the Turks defeated the Italians, and city leaders could not pay its citizens, they proposed that its citizen-borrowers get a 6% interest payment until the loans were repaid in full. The citizens approved the proposal. This simple event created an entirely new financial market.
The idea that bonds could be issued to pay for wars and other large national or municipal capital projects proved very popular. Spain issued bonds to finance its exploration of South America, while Holland used bonds to build dikes. Other western European economies expanded rapidly using funds raised by issuing bonds.
In the U.S., Congress issued bonds to fund the Revolutionary War, and these became the first financial instruments traded when the New York Stock Exchange was founded in 1792.
Today, almost all public, corporate, and hybrid public entities issue bonds using the same essential elements from the 14th century: an issuer lends money at a specific interest rate for a particular period that pays predictable interest payments to the bondholders.
What are Bonds, and How Do Bonds Work?
Bonds are loans issued by a lender to a borrower. The lender, or bond issuer, can be the U.S. government, states, municipalities, federal agencies, corporations, or foreign nations.
Bond issuers agree to pay purchasers a rate of interest throughout the loan as well as the principal (the face value of the bond) at the bond's maturity date.
This income stream relies on the interest payments plus the principal payment when the bond matures. What determines bond prices are its coupon and maturity. The greater the coupon, the more expensive the bond. The longer the maturity, the cheaper the bond since it has a higher interest rate risk exposure.
The bonds most sensitive to interest rate risk (also known as "market risk") are those with longer maturities and smaller coupons.
If an investor expects interest rates to increase, a bond with longer maturity and a smaller coupon would be attractive. The opposite is true if an investor expects interest rates to decline.
This price/yield relationship is very mathematical. More sophisticated bond traders can input the factors that determine bond prices - interest rate, coupons, maturities - to predict bond performance in a summary measure called "duration."
Bonds are attractive to individual investors because they pay interest regularly, often semi-annually, and are used for capital preservation since bond defaults are rare. They are ideal for capital preservation, especially if they have a short maturity, generating income and risk management.
What are the 5 Types of Bonds?
The U.S. fixed income market is the largest in the world and comprises some $42 trillion in issuances (as of 1Q 2020), according to SIFMA. The U.S. bond market encompasses bonds accessible to individual investors and another primarily institutional segment that trades in large denominations between broker-dealers.
The five types of bonds most commonly sold to individuals are:
1. U.S. Treasury bonds and notes
This category of bonds has almost no credit risk since the U.S. government has a AAA rating. These bonds and notes come in a range of maturities ranging from one to 30 years. It's a $19.8 billion market, according to SIFMA.
2. State and municipal bonds
These are issued by state and local governments or agencies, as well as utilities and school districts to pay for large public projects, such as infrastructure construction.
3. Agency Bonds
These include Freddie Mac, Fannie Mae, Ginnie Mae, Federal Home Loan Bank Corporation, and the bonds of other federal agencies. However, they are not backed by the U.S. or local governments, so they have higher credit and default risks.
4. Corporate bonds
Corporate bonds are issued by high-quality, investment-grade public and private corporations to expand or raise capital for investments.
This sector has more risk than U.S. Treasuries, so they pay a high-interest rate. These bonds are rated by established credit rating agencies to evaluate the borrower's ability to repay their debt over time. Corporate bonds are $10.4 billion in issuance as of 2Q 2020, according to SIFMA.
High-yield corporate bonds are low-quality, lower-rated bonds also known as "junk bonds."
Junk bonds are a more recent addition to the bond market. They first appeared in the 1980s to finance LBO deals. The high-yield debt instruments were developed by Michael Milken of Drexel Burnham to fund the often-hostile bidders in LBOs with the needed funds to acquire companies without going to traditional lending sources such as banks and established investment firms.
Today, there are $1.2 trillion in junk bonds, and they remain an attractive area for speculative investors. The main dangers in these bonds are the credit and business risks of the issuer. These risks are why many junk bonds tend to trade the price of the issuer's stock.
5. Foreign sovereign bonds
Foreign sovereign bonds are issued by nations worldwide. Their rates are determined by the nation's creditworthiness, maturity, and currency risk.
Other Bond Varieties and Hybrids
There are other categories of bonds that are traded by institutions. These include:
- Money market instruments
These can be certificates of deposit, bankers' acceptances and commercial paper with very short maturities ranging from overnight to one year. Repurchase Agreements are between institutions and are a cash management tool.
- Mortgage-backed securities (MBS)
Mortgage-backed securities are secured by mortgages that are collateralized by real estate. They are less liquid than other types of bonds and are often packaged into MBSs, using pass-throughs or collateralized mortgage obligations (CMOS).
- Asset-backed bonds or notes
These bonds are pools of debt obligations securitized by financial assets, such as accounts receivable (excluding mortgage loans), credit card receivables, auto loans, manufactured-housing contracts, and home-equity loans.
The price of these bonds often is quoted as a spread to a swap rate. Prices also are based on the credit quality and maturity of the bonds.
Bondholders are repaid by the cash flows of the debt obligations, so they can receive interest and principal repayments.
Pros and Cons of Bonds
Given their long history, product variety, and demonstrated risk/return characteristics, bonds are an essential element in any diversified portfolio. Compared to stocks, bond prices are more stable, so they are less suited for trading as opposed to long-term investing. They provide a more stable interest income stream and return of principal when the bond matures.
Bonds also are subject to price changes from rising interest rates, market volatility, and changes in the issuer's credit quality. In a rising interest rate environment, bond prices fall. Some bonds, often corporates, can be called before maturity. This could force the investor to re-invest in bonds paying a lower interest rate.
Bonds Belong in Every Portfolio
Bonds are a critical asset class and belong in every individual portfolio. They can reduce overall risk, preserve capital, and deliver a constant stream of interest payments.
However, understanding bond basics is just the beginning. Many factors can impact a bond or bond fund's value such as interest rate changes, the overall economy, and the issuer's financial prospects. To make the best fixed income selections, investors should work with a financial or robo-advisor to develop, execute, and monitor their strategy.
Key Bonds Terms
This is the rate of interest paid annually.
Bonds are called when the issuer redeems the bond before its maturity date. Bonds may be called when rates drop, and the issuer then reissues the bond at a lower interest rate. This means an investor's principal will be returned and re-invested in a bond that pays a lower rate.
This refers to the yield difference, often compared to a U.S. Treasury security, that reflects the issuer's credit quality. Credit spreads are the difference between the value of two securities with similar interest rates and maturities, when one is sold at a higher price than the other is purchased.
The current yield is the ratio of interest to the actual market price of the bond, stated as a percentage. If a bond has a face value of $10,000 and pays a 6% coupon, the current yield is $600 per year.
Defaults happen when the issuer fails to pay principal or interest when due.
Inverted (or negative) yield curve
When short-term interest rates are higher than long-term interest rates, the yield curve is inverted.
Positive yield curve
When rates are graphed along axes that represent time and interest rates, short-term rates should be below long-term rates.
In some instances, when the price of a bond exceeds its principal amount, the bond is trading at a premium.
Taxes impact the prices of bonds. The true yield refers to the real rate of return to the investor. This includes the payment of capital gains at maturity for a bond bought at a discount.
Yield to maturity
The yield to maturity is the sum of all interest payments investors receive until the maturity date. This is how much the bond will return in a year based on its price and interest rate. This calculation is made by dividing the interest payment by the price.
Yield to call
Yield to call is very similar to yield to maturity. However, sometimes a bond is called before its maturity date, so the amount of interest received is reduced.