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Quick Explainer: Understanding Bonds

November 11, 2016

  • A bond is a loan, and you’re the lender.
  • For most bonds, payments of interest occur at a predetermined rate and schedule.
2 min read

Bonds are financial instruments, specifically, debt instruments.

Debt instruments (not to be confused with drums and guitars) are an essential part of the economy and part of a balanced investment portfolio.

A bond is a loan, and you’re the lender.

What are bonds for?

Sometimes a company, municipality, or government needs to raise funds. They might need funds to grow, develop, finance projects or operational costs, facilitate activities…or even make the payments on previous bonds.

An investor (that’s you) can then loan money to the company or government  by purchasing those bonds. But why would you want to loan a company or government your hard-earned cash?

The answer is a fixed-interest rate. Depending on the kind of bond it is, you should know when and with how much interest you’ll be paid back. You know how much money you are going to receive in interest in addition to getting the amount you lend back, and when.

Bonds are known as fixed-income securities.

Are there different kinds of bonds?

It is important to note that all bonds (and all debt) are not created equal. Some debt is rated highly, and other debt is rated poorly.**

Highly-rated debt is called investment grade.

This indicates that the entity to which you are loaning your money has a very high chance of paying you back. Non-investment grade debt is sometimes called junk.

Examples of Investment Grade Debt:

If a company isn’t rated as investment grade, they need to increase the incentive to buy their bonds, and they usually do this by offering a higher interest rate or coupon.

What’s the coupon rate?

When talking about bonds, the coupon refers to the annual interest rate paid on a bond.

For most bonds, payments of this interest occur at the predetermined rate and schedule (remember the fixed part of fixed-income security).

Once upon a time when bonds were pretty pieces of paper rather than electronic transactions, coupons were bits of paper torn off of a bond and redeemed. Suddenly the term coupon makes a bit more sense.

Coupon rate vs. par value

Don’t worry, we’ll explain it. A coupon rate is the annual coupon payment received, relative to the bond’s face or par value and expressed as a percentage. Par value is super easy to understand.

Par Value is the value the bond has on its maturity date. This is the value of your bond, it’s what you pay, and it’s printed right there on the bond. Bonds can have different maturity rates, from as little as a month to 100 years.

The maturity date is the the day you get back the money you initially invested. This is your principal.

Now you know more about bonds!

Learn more about how bonds can fit into your portfolio here

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By Lindsay Goldwert

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*Bonds can also have variable interests rates. But we are focusing on the basics here. Let your curiosity lead you if you’d like to discover more about these variable interest rates after this Jargon Hack.

**The “Big Three” of credit rating agencies are the S&P, Moody’s, and Fitch. Here’s a handy table of these ratings!

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.  Bonds sold or redeemed prior to maturity may be subject to loss.

This material has been distributed for informational and educational purposes only, represents an assessment of the market environment as of the date of publication, is subject to change without notice, and is not intended as investment, legal, accounting, or tax advice or opinion. Stash assumes no obligation to provide notifications of changes in any factors that could affect the information provided. This information should not be relied upon by the reader as research or investment advice regarding any issuer or security in particular. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

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