A bond is a fixed-income instrument that represents a loan made by an investor to a borrower, which can be a corporation or a government. The borrower uses the capital and, in return, pays the investor periodic interest (known as the "coupon") over the life of the bond and repays the original loan amount, or "principal," at a specified future date, known as the maturity date.
In essence, when an investor purchases a bond, they are lending money to the issuer. Bonds are a fundamental tool for organizations to raise capital for projects, operations, or refinancing existing debt. For investors, they are a core component of many portfolios, typically providing a more stable and predictable income stream compared to equities. Unlike stocks, which signify ownership in a company, a bond is fundamentally a debt instrument, making the bondholder a creditor to the issuer.
The relationship between risk and reward is central to the bond market. The higher the perceived credit risk of the issuer, the higher the interest rate they must offer to attract investors.
A bond is defined by several key characteristics:
- Face Value (or Par Value): This is the amount of money the issuer agrees to repay the bondholder at the maturity date. It is the principal of the loan.
- Coupon Rate: The annual interest rate paid on the bond's face value. Payments are typically made semi-annually. A "zero-coupon bond" pays no periodic interest; instead, it is purchased at a discount to its face value.
- Maturity Date: The specific date in the future when the issuer must repay the bond's face value. Bond maturities can range from very short-term (less than a year) to very long-term (30 years or more).
- Credit Quality: An assessment of the issuer's financial health and ability to make its promised payments. Credit rating agencies like Standard & Poor's and Moody's assign ratings to bonds, ranging from the highest quality (e.g., AAA) to very speculative "high-yield" or "junk" bonds.
Concrete Examples
- Government Bond: An investor looking for a low-risk investment purchases a 10-year U.S. Treasury bond with a face value of $1,000 and a 4% coupon. The investor will receive $40 in interest each year. At the end of the 10 years, the U.S. government repays the original $1,000 principal to the investor.
- Corporate Bond: A major technology company needs to raise $1 billion to build new data centers. It issues corporate bonds with a 5-year maturity. Pension funds and other institutional investors buy these bonds, attracted by the higher coupon rate compared to government bonds, while accepting the slightly higher credit risk associated with a corporation.
- Green Bond: A utility company issues a Green Bond specifically to finance the construction of a new wind farm. Investors who prioritize sustainable investments purchase these bonds, knowing their capital is directly funding a project with positive environmental impact. This aligns with a broader strategy of investing based on ESG Criteria.
The market value of a bond can fluctuate before its maturity, primarily influenced by changes in prevailing interest rates and the creditworthiness of the issuer.
Bonds are opposite to actions.