As a financial advisor, you know your way around bonds, and I’m sure you’ve talked with your clients about them. While your clients may recognize the term and the general concept, do they understand the jargon and conventions surrounding bonds and their usage?
What is a bond? Trying to find the right way to explain and break down how bonds work, starting from the basics for a client, can be a lengthy process. Dunham is happy to help you save time so you can focus on other aspects of your practice.
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The Finance Essentials Series seeks to explore, clarify, and explain concepts you may see as common knowledge, but your clients view as technical jargon. This week, we will examine the primary features of bonds.
What is a bond?
Most people have heard of a bond and may have a vague idea of what it means. An excellent place to start is with a simple definition.
In essence, you could think of a bond as a loan made by an investor to a borrower. Typically, the borrower is either a corporation or the government. A bond is a fixed-income instrument that generally provides fixed periodic interest payments, and the borrower pays back the original amount of the loan at the maturity date.
Simply put, a bond is like an I.O.U!
Bonds come with various terms that refer to different elements concerning the function and characteristics of bonds. Keeping these terms straight can be tricky, so having them defined will help you understand bonds.
- Maturity Date: The date the borrower needs to pay back the bond’s principal.
- Issuer: the entity who borrows the money and owes interest and principal to the bondholders.
- Trading at par: Traders will typically set the initial price of a bond at $1,000. When it trades at $1,000, we call this “trading at par.” When the bond matures, it typically matures at par. However, historically, bond prices will fluctuate up and down, making the following two definitions essential.
- Trading at a premium: This means the bond is trading over the $1,000 par value. As a hypothetical example, if the bond increases in value from $1,000 to $1,100, it is said to be trading at a premium.
- Trading at a discount: This means the bond is trading under the $1,000 par value. Hypothetically, if the bond price went from $1,000 par value to $900, this would imply you are selling it for a $100 loss. Said differently, at a $900 price for the bond, we would say it trades at a “discount” from its $1,000 par value.
- Callable Bond: With this bond, the borrower can pay back the bond before the bond’s maturity date. These bonds may be called or paid off when interest rates go down.
- Non-Callable bonds: This is where the borrower (issuer) can only pay back the loan on the maturity date.
- Coupon Rate: This is the interest rate the bond issuer (borrower) will pay on the bond expressed in the form of a percentage of the par value of the bond.
- Default: The term default refers to when a borrower does not make interest and principal payments. Historically, the lower the credit rating of a bond, the more likely they default.
- Bond’s Duration: Duration, also known as interest rate sensitivity, measures how much a bond’s price will increase or decrease as interest rates go higher or lower.
- Face value: The face value is what the borrower will pay back when the bond matures or reaches its end date.
- Investment Grade: An investment grade signifies that a bond has a lower risk of default and is more likely to be paid back. For bonds, the highest rating is ‘AAA’. A bond with a rating less than ‘BBB,’ is considered a junk bond or high-yield bond.
- Junk Bond: A junk bond, also known as a high-yield bond, has a higher coupon payment but has a higher risk of default. It is rated BBB or less
- Principal: A principal is the beginning sum of money, before interest, that the bond issuer needs to borrow.
- Maturity Date: The maturity date is when the principal amount of the borrowed funds, in the form of a bond, need to be paid back by the borrower.
- Variable Interest: When a bond has a variable interest rate, the bond’s interest rate fluctuates based on a benchmark or index interest rate.This kind of bond does not have a fixed rate of interest.
- Yield to Maturity (YTM): The YTM of a bond is the compounded annualized rate of return that the investor (lender) receives had they held the bond to maturity [ii].The YTM will be different at different times of purchase.
Before you start making flashcards on all the terms I threw at you, know that you don’t need to know all these terms by heart to understand what a bond is. These terms come in handy when discussing bonds and how they work. They also may be good to impress your friends at parties.
How are bonds priced?
Bond prices are not just decided by someone with a knack for pricing items. There is an economical process to how these prices are derived. The price of a public bond could change the second their markets are open, just like the price of a publicly traded stock.
The supply and demand expressed by the market is one determinant of a bond’s price, but the most prominent factors affecting a bond’s price are the present value of the money to be borrowed and the creditworthiness of the borrower. The value of the bond is derived from how these details compare to bonds with similar characteristics.
The price of a bond and interest rates have an inverse relationship. This means that when one goes up, the other goes down.
This why when interest rates go down, bond prices go up and this is when we say a bond is trading at a premium.[iii]
If interest rates for bonds of a similar maturity and credit quality increase and are more than your bond’s interest rate, your bond becomes less valuable because it pays less income than bonds with now available with higher interest rates.
This is why when interest rates go higher, bond prices go down, and it is said that the bond is trading at a discount.
How are bonds different than stocks?
The main difference between stocks and bonds is what they represent. When you purchase a stock, you purchase partial company ownership. When that company does well, the value of your stock may go up. A bond represents a loan that you, the investor, make to the issuer or borrower of the loan.[v]
As an investment, bonds are a complex vehicle for many to understand. Take time to speak with your financial advisor to learn more about bonds and how they fit into your portfolio.
The financial world can be full of confusing and complicated to understand topics that may need to be clarified between you and your clients. We hope this article will help bridge the understanding gaps between your clients and you and facilitate direct and productive client-advisor relationships.
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