In this week's issue of intro to investing, we will be talking about bonds and the debt markets.
What is a Bond?
Bonds are debt instruments whereby an investor holds a bond representing a loan made to the borrower. Bonds have a fixed period whereby the lender pays the holder of a bond a fixed income. These are commonly coupon payments which are a fixed or variable percentage of the face value of the bond (the value received by the investor at maturity). These work similar to interest payments on a loan; however, no principal is paid. The principal is paid in one lump sum at 'maturity', which occurs at the end of the defined period of the bond.
Bonds work differently from shares and are classed in a different asset class. Governments, states, and companies commonly use bonds to finance expansions and expenditures that require more capital than an individual bank can lend.
Debt markets
Bonds can be traded like shares, with some bonds being listed and traded on stock exchanges. Many bonds are traded over the counter (OTC) through brokers and dealers rather than on a centralized exchange. The market is broken into a primary market, where the bonds are initially issued, and the secondary market, where bonds can be freely traded between investors.
Bond prices
In the secondary market, bond prices can fluctuate based on several factors. The most significant is the bond yield, which is a summary of the investor's remaining interest and principal payments in its current dollar price. Yields fluctuate based on market conditions and are sensitive to changes in the prevailing interest rate. Yield has an inverse relationship with price, so the bond price will fall as it increases. The quality of the bond will also have a significant effect on the price. This is based on a credit rating given by a third party, evaluating the overall ability of a debtor to pay back their debts. This is usually denoted by letters, with AAA being the highest (lowest risk) and CCC being the lowest (highest risk). Higher default risk will lead to a higher yield on the bond, as investors expect a higher return for taking on the risk.
Summary
Bonds are debt instruments that represent a loan between the investor and a borrower. These bonds can be freely traded between investors on the secondary market. Bonds represent a relatively low risk for investors to earn a predictable fixed-income yearly.