Bonds: How Lending Investments Work

By the end of this lesson, you should be able to:

- Explain a bond as a loan from an investor to an issuer. - Identify face value, maturity date, coupon rate, and yield to maturity. - Describe why fixed-rate bond prices generally move opposite to market interest rates. - Explain why selling before maturity can produce more or less than face value. - Recognize major bond risks and distinguish lending through a corporate bond from owning company stock.

Imagine lending money to a government, municipality, or company. The bond is the record of that loan. Under the bond’s terms, the issuer generally promises to repay the principal at a specified maturity and may pay interest along the way.

A bond is different from a stock: buying a corporate bond means lending to the company, not automatically becoming an owner of it.

A bond is a debt security. An investor lends money to an issuer, which may be a government, municipality, or corporation. The issuer generally promises to repay the principal at maturity and may pay interest according to the bond’s terms.

The main ideas to track are:

- The issuer: the borrower. - The investor: the lender. - The principal or face value: the amount associated with repayment at maturity. - The maturity date: when the bond’s term ends. - The coupon rate: the bond’s stated interest rate. - The yield to maturity: a return measure for a bond bought at its market price and held to maturity.

A fixed-rate bond’s stated payments do not automatically change when market interest rates change. As a result, existing fixed-rate bonds generally become less attractive when newer bonds offer higher market rates, so their prices generally fall. When market interest rates fall, existing fixed-rate bond prices generally rise.

Yield to maturity should not be treated as a guaranteed realized return. It is a measure defined for a bond bought at its market price and held to maturity. Its interpretation therefore relies on those stated assumptions, including holding the bond to maturity. A sale before maturity can produce a different result because the bond’s market price may have changed.

The basic sequence is:

1. An issuer raises money by borrowing through a bond. 2. An investor buys the bond and becomes a lender under the bond’s terms. 3. The issuer may make interest payments as specified. 4. At maturity, the issuer generally promises to repay principal, subject to the bond’s terms and the issuer’s ability to meet its obligations. 5. If the investor sells before maturity, the amount received depends on the bond’s current market price and may be above or below face value.

For corporate bonds, the investor receives a debt claim rather than ownership equity merely from holding the bond.

Suppose an investor owns a fixed-rate bond and market interest rates later rise. Existing fixed-rate bond prices generally fall, so selling that bond before maturity could result in receiving less than its face value. If market interest rates instead fall, the bond’s market price may rise, and a pre-maturity sale could produce more than face value.

This example shows why a bond’s stated interest rate and its market price are different ideas. It also shows why yield to maturity is not the same as a guaranteed result for someone who sells early.

Quick learner check: If market interest rates rise, which direction would you generally expect an existing fixed-rate bond’s price to move?

Bond investors may face several risks:

- Credit or default risk: the issuer may fail to meet its obligations. - Interest-rate risk: changing market rates can change the market price of a bond. - Inflation risk: inflation can affect the purchasing-power value of bond payments. - Liquidity risk: it may be difficult to sell a bond at a desirable price. - Call risk: a callable bond may be retired before maturity under its call provision.

These risks mean that a bond is not automatically risk-free simply because it has scheduled terms. The relevant risks depend on the bond and its issuer.

- “A bond is the same as stock.” Not generally. A corporate bond represents lending to a company; it does not provide ownership equity merely because the investor holds it. - “A bond always sells for its face value.” Not necessarily. Market prices can move above or below face value, especially when a bond is sold before maturity. - “Yield to maturity is the return everyone will definitely earn.” No. It is a measure based on buying at the market price and holding to maturity; selling earlier can produce a different outcome. - “Higher market interest rates make existing fixed-rate bonds more valuable.” Generally the opposite occurs: existing fixed-rate bond prices generally fall when market interest rates rise.

A bond is a loan made by an investor to an issuer such as a government, municipality, or corporation. The bond’s terms may specify interest payments and repayment of principal at maturity. Important terms include face value, maturity date, coupon rate, and yield to maturity.

Bond prices generally move opposite to market interest rates for existing fixed-rate bonds. Selling before maturity can result in receiving more or less than face value. Yield to maturity is an assumption-based measure for buying at market price and holding to maturity, not a guaranteed realized return. Finally, bond investors should understand credit, interest-rate, inflation, liquidity, and possible call risks.