What are bonds | Basic bond terms

By | September 26, 2013
A bond represents money lent. Buying a bond essentially means you are lending money to the entity selling the bond. This entity could be the Government, a company, a municipality, a federal agency or a private agency sponsored by the Government.The amount that you pay to purchase a bond is called the face or principal value. Bonds pay an interest which is a percentage of the face value. When interest is paid in installments – generally semi-annually, it is called a coupon payment. Bonds can be short term or long term going to several years. When the duration of the bond interest payments is over, the bond is said to have matured. When the bond matures the purchaser of the bond gets back the face value of the bond.

When bonds are first issued, the price is the same or very close to the face value. When bonds are purchased in the secondary market the price that you pay can be higher or lower than the face value. When the price is higher than the face value the bond is said to be selling at a premium. When the price is lower than the face value it is said to be selling at a discount. When the price is the same as the face value, the bond is said to be selling at par.

The price of a bond fluctuates depending on factors such as interest rates, maturity of the bond, credit rating of the bonds, liquidity, supply and demand and general market conditions.

Bonds can have a fixed interest rate or a floating interest rate pegged to the treasury rate,  LIBOR or other standard interest rate index.

Bonds can also be zero-coupon. This essentially means that interest is not paid during the life of the bond but only when the bond matures.

A bond’s yield refers to the return earned on the bond based on its interest rate and price paid.

Bonds can be of various maturities – short term which are generally 1 to 5 years, medium term which are 5 to 12 years and long term which are for maturities of longer than 12 years and generally upto 30 years.

Bonds can have call and put provisions. The bond issuer can specify a price and date that the bond can be redeemed before maturity. Such callable bonds generally have higher interest rates. Bonds that have a put option allow the bond purchaser to sell the bond to the issuer at a price and date before maturity. Such bonds generally have lower interest rates since the risk to the purchaser is less.

Companies may issue bonds that are convertible to stock. These bonds also have a lower interest rate since they may be converted to stocks.