In a Nutshell: A bond is debt interest, a glorified “IOU.”
Definition: A bond is a debt investment. It is the opposite of an equity investment. A bond is basically a piece of paper that says “I owe you money, which I’ll pay back at interest.” The bond holder (or bond investor) is the party who made the loan, the bond issuer is the party who asked for the money. The amount borrowed is the “principle” and the rate of interest the borrower pays to get the loan is called the “coupon.” Another fancy term in the bond world, one which is regularly confused with the “coupon” is the term bond “yield,” which is easily arrived at by simply dividing the coupon rate by the bond price, or Y = C/P.
Lemonade Stand Example: Jane and Billy have a lemonade stand that is doing pretty well, making lots of profits on Elm Street. They are thinking about opening another stand on Main Street, possibly even Oak Street as well. You really want to be a part of their story and share the upside of its success, but you don’t have time to buy lemons or fill cups or work the lemon press. Meanwhile, Billy and Jane could use some cash to open that Main Street stand. They heard you had an unusually rich uncle and lots of allowance, so they come to you and ask for a $100.00 loan (its “par value”). They even have piece of paper, they call it a bond instrument, which promises to pay you 5% interest (the coupon) over five years for the loan, at the end of which (the “maturity date”) the loaned amount is to be paid back in full.
Fancy/Alternative Names: “Credit” or “Fixed Income.”
Advantages: As long as the bond issuer doesn’t default or inflation doesn’t eat away at the value of your money at a rate higher than the yield and coupon return of your bond, such instruments can often offer a nice return on investment. Traditionally, bonds also served as “less risky” alternatives (as well as diversifiers) to stocks in a personal portfolio.
Bond holders also have priority over stock holders if a company is failing. In the lemonade stand example, if Billy and Jane were closing down their juice stand, they’d have to pay the people they borrowed from (i.e. the bondholders) before they allocated leftover funds (if any) to the stockholders.
Risks: The main risks in any bond investment are threefold: 1) default risk, 2) interest rate risk and 3) inflation risk.
Default Risk. In the lemonade stand example, if Billy and Jane end up fighting over the color of the cups or the size of the straws, or if Billy gets jealous about Jane’s new boyfriend in the 4th grade, the business could just fold and the money you lent them never gets paid back. That’s default risk. In the real bond world, this is rare, but it does happen. Risk of default increases as you go from government bond issuers (like the U.S. Treasury Bonds) to less credit-worthy corporate bond issues, known, appropriately as “junk bonds” (but sometimes misleadingly called “high yield bonds.”) In between Treasuries and Junk bonds lives an entire range of other bond instruments, from municipal bonds (aka “muni’s” that are issued by municipalities/cities) to high grade corporate bonds (issued by corporate entities). As oil prices fell from $140/Barrel to $27/Barrel in 2015-2016, a lot of small shale companies that had issued bonds at a par value of 100 in good times found themselves defaulting on those bonds in tougher times.
Interest Rate Risk. Suppose in the same town as the Billy and Jane lemonade stand, you have a clever 3rd grader, Bertha, who has an idea. She’s got a fairly sizable piggy bank called The Bertha Bank. She uses this oddly named piggy bank to loan money to lots and lots of other 2nd and 3rd graders, and charges them a “Bertha Rate” of interest for the loans/bonds. She then sells those Bertha-Rate bonds to other kids. Meanwhile, Bertha has an equally clever twin named Bert, who has set up an exchange in the park, where kids who made bond investments to Billy and Jane or kids who bought Bertha Rate bonds, can come to his counter and sell their bonds to other kids over the counter—or “OTC.”
When times are good and the lemonade stand and others are doing well, these bonds can sell OTC for more (at a “premium”) than their original 100.00 par value. However, when times are tough for the lemonade stand in particular or the neighborhood economy in general, kids try to get quick money and thus seek to dump/sell their bonds to the kindergarteners for a “discounted” price below par, say at $80.00 instead of $100.00. (And remember, if Y=C/P, then these discounted bond prices (the P) result in higher “yields” (the Y) for the new holders/investors of the bonds; alternatively, when bond buying demand is high, bonds can often be resold at a premium above the par price (i.e. for $105.00 instead of $100.00), which means the bond yield goes down as the bond price goes up).
Let’s say Bertha over at the Bertha Bank decides to raise the interest rate she offers buyers of Bertha Bonds to a rate higher than the coupon rate (the C) that Jane and Billy are offering for their lemonade bonds. It makes sense for holders of the lemonade stand bonds to sell those and buy Bertha Bonds with its higher coupon rate. So everyone starts selling the lemonade stand bonds, naturally causing their prices to go down (as occurs in every “sell-off”). In short, there is an inverse relationship to rising rates and bond prices. As rates rise, the bond prices (the P) go down (and hence their yields—the Y-- go up). There is a similar inverse relationship between rising inflation rates and bond prices, that is, as inflation rates increase, bond prices tend to fall.
The Bertha Bank rate hike is no different than a Fed rate hike in the current bond markets. As the Fed raises or lower rates, bond prices go up or down accordingly. That is, all the bonds in your portfolio, whether Treasuries, Muni’s, Corporates of Junk, live in the same universe as the lemonade stand and The Bertha Bank—otherwise known as the US Central Bank, or Federal Reserve, whose chairman or chairwoman, just like Bertha, control short term interest rates, which impact bond prices and yields.
Further Reading: For more on credit markets/bond markets and their risk see, “The Global Debt Bubble;” for more on the role of bonds in a portfolio see Section 6 of “The Six Portfolio Secrets,” see also “Portfolio Construction and Asset Allocation.”