An Introduction To Bonds And Their Role In The Stock Market

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Bonds have long been regarded as the dull, underperforming alternative to stocks. However, bonds play a key role in most portfolios, and it is critical to grasp the nature of this alternative to the stock market.

A bond is essentially a loan. The holder of a bond has given the issuer—whether a corporation, government, or another agency—a quantity of money that can be utilised at any time. In exchange, the issuer will pay the bondholder interest over time and eventually return the original loan amount, known as the principal. Unlike stockholders, bondholders do not own a portion of the corporation.

Bonds are commonly referred to as “debt securities” since they reflect a debt obligation from the issuer to the bondholder. Bonds are frequently referred to as fixed-income securities. The rationale for this term is that the amount of income and the timing of payments are known to the purchaser at the time of purchase of a basic bond. Bonds are also known as debentures and debt instruments.

At the time of purchase, the characteristics of the bond will be stated in the certificate.

Here are the items that will be specified on most (but not all) bonds:

• Time to Maturity – This is the date the issuer will make a lump sum payment to return the principal to the bondholder, which eliminates the debt.
• Principal, par value, face value – These are three names for the same item, the amount that will be returned to the bondholder at maturity. The most common face value is $1000.
• Coupon – This is the interest payment that will be made to the bondholder. Generally, a percentage of the face value will be fixed which will represent the annual interest rate on the loan. Also, a timetable will be set up for the payment of the coupons, usually semiannually. Not all bonds pay out interest through coupon payments.

Note: The principal may or may not be the price you pay for the bond. Depending on when the bond is purchased, you may pay more or less than the par value. Often, bonds are sold below par when they are issued; this is being sold at a “discount.” Selling bonds at a discount creates an added incentive for people to buy the bonds, because at maturity they will be getting back more than the initial investment. At times, bonds will be sold at a premium, which means that they are sold at a price above par, and income is generated from interest.

Bonds are traded in two markets: the main market and the secondary market. When a bond is first issued, it is in the primary market. The bond is purchased directly from the issuer in the main market (the details of buying and selling bonds will be covered later). When bonds are sold from one bondholder to another, they enter the secondary market. Bond prices in the secondary market are determined by supply and demand, and are influenced by expectations for interest rates and inflation, the number of coupon payments remaining until maturity, and the length of time until the bond expires.

There are many types of bonds. The different types of bonds are usually defined by the issuer, though some are defined by the characteristics of the bonds. These topics are covered in detail throughout the rest of this section, but here is a quick list of some of the major types of bonds:

• Corporate Bonds
• Municipal Bonds
• Treasury Bonds
• Agency Bonds/Mortgage-Backed Securities
• Zero-Coupon Bonds
• Junk Bonds

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