By Will Sun
In the 1980s, Michael Milken, aka the “Junk Bond King,” was the epitome of greed. Inventing a new means by which startup companies could reliably raise money, Milken was critical in the development of bond funding to support necessary acquisitions. Unfortunately, he was found guilty of fraud in 1989, ruining his reputation forever.
While Milkens may have put a bad rap on bonds, today, bonds are a significant part of the investment landscape, with the bond market being a whopping $119 trillion! With the first bond being issued in 1935, bonds have existed in America for a long time. But how exactly does one invest in them? On a more important note, what exactly are bonds?
What are bonds?
Bonds are a specific type of investment called fixed-income security. Essentially, this type of investment raises money through fixed periodic interest payments at specific increments of time, as well as the return of principal at maturity. A return of principal simply means that a payment is made based on a portion of the money originally invested into the bond (principal is the original amount of money put into an investment.) Maturity refers to the date on which borrowers are required to pay in full the principal amount of the investment- with this, interest payments also end.
But confusing jargon aside, what exactly are the bonds themselves? A bond can be visualized as an I.O.U, a document/statement acknowledging the existence of a debt, between the lender, which is typically the investor, and the borrower/bond issuer, which is usually a corporation or the government. Used by many companies, states, and even sovereign governments, bonds are a tremendous source of income and a way for big companies and groups to finance large projects, from civil infrastructure to expanding their business. For instance, way back in 1917 during the first World War, the US government used “liberty bonds,” where citizens would give money to the government to finance and fund its soldiers, equipment, and vehicles.
Between the investor and the borrower, the bond has key benefits for both parties. While the corporation or borrower receives a specific amount of money for a specified timeframe, the investor who gave the money received periodic interest payments. One unique benefit for bondholders/investors is that bondholders can sell their bonds to other people before the maturity date.
Almost all bonds have certain features that are important to take into account.
Face Value/Issue Date- The face value of the bond is the total amount of money the bond will be worth when it reaches maturity- this means it includes the principal as well as every periodic interest payment made. Used as an important measurement of the value of bonds, face values are also the value that issuers of bonds use to determine how much interest payments will be. For instance, while one person may buy a bond at $1,500 and another person may buy the same bond at a lower price of $1,000, both people will receive the same face value of $1,500. Additionally, the issue date of the bond also indicates when interest begins to accrue.
Maturity Date- The maturity date is simply the time when the borrower will pay back all of the principal initially invested. This date is important to keep in mind as it also signifies the end of the periodic interest payments.
Coupon Rates/Date- The coupon rate indicates the interest rate that the investor will receive on the face value of the bond. For example, if an investor bought a bond at $500, and the coupon rate is 10%, the investor will receive an interest payment of $50, or $500 x 10% at the specified time. This specified date at which the bond issuer will give the interest payment is known as the coupon date. Usually, this occurs semiannually, or twice per year.
An important thing to remember is that an investor’s credit score and the time to maturity are the primary factors that influence the coupon rate. Both lower credit scores for the bond issuers and longer maturity times create higher coupon rates.
Issue Price- The issue price is the price at which bond issuers initially sell bonds.
With the basics of bonds out of the way, what are the primary types of bonds? Generally, there are 4 primary categories of bonds available within the market.
Corporate bonds- These bonds are issued by companies such as Apple, AT&T, and Amazon. Many companies often prefer bonds due to lower interest rates and market adaptations.
Municipal Bonds- These bonds are issued by state governments and municipalities, or cities/towns that have both a local government and corporate status. With these, some bonds have the additional benefit of tax-free interest payments.
Government Bonds- These bonds are issued by the U.S. treasury. The type of government bonds is categorized by the time to maturity. (1 year or less = “Bills,” 1 year to 10 years = “Notes,” 10 years to maturity = “bonds.”)
Agency Bonds- These bonds are issued by government-related organizations that are not the U.S. department of treasury. These can also be given out by government-sponsored enterprises such as mortgage issuers Freddie Mac.