How Bonds Work
When you purchase a bond, you are stepping into a contract wherein you are the lender of a certain amount of money to another party, and that party pays you an agreed upon amount of interest each period, with a plan to return the amount they borrowed at some agreed upon expiration date.
The borrower can be almost any kind of entity; for example, you could purchase bonds from the US government, your state government, or a business. These different parties have different risk profiles, which means when they go out to borrow money, they offer different interest rates to you as the lender. After all, if you could get 4% interest from the US government vs the same from Uncle Joe’s coffee shop, which would you choose? It is much less likely for the US government to default on their loan than Uncle Joe’s, so you would have to be compensated for the extra risk you take on by lending to Uncle Joe’s.
Below are bond quotes from Fidelity. There are just a few pieces of information that will tell you a lot about the bond you are considering.
Basis Point: A basis point is 1/100th of a percentage point. 100 basis points equals 1 percentage point.
Par Value: Par Value is the nominal amount the borrower agrees to repay at the end of the loan.
Coupon: This is the percent you’d earn in interest if you bought the bond at the current quoted price.
Bid/Ask Price: This is the price being asked by the current most competitive buyer (bid) and most competitive seller (ask). The price is expressed as a fraction of par value. So in the case of Ford, the most competitive buyer is willing to pay 99.407% of par value. The most competitive seller is willing to sell at 99.645% of par value.
Yield: This is the estimate of how much you’d make annualized if you held the bond to maturity and purchased it at the quoted price. Notice that the yield is not identical to the coupon. The main reason for this is because you are often not purchasing the bond at par value, or the amount promised to be paid back in principal by the borrower. In the case of the Ford bond at the top, you are paying below par value for it and so when the loan comes dues, you will be paid more than you actually paid for the bond. That should be factored into your overall returns.
Maturity Date: This is when the loan expires and they are required to pay back the amount owed. Keep in mind that the amount they owe is often not the amount you paid for the bond.
Moody’s/S&P: These are two of the largest rating agencies. They provide a standardized set of ratings for the risk quality of the bonds.
Yield to Worst: This is the worst overall return you could expect to get without the borrower defaulting. How can this be lower than the coupon rate? There are certain provisions in a bond that could affect your return. The borrower may have a call option, which is a right to purchase back the bond from you during some time window. They may have an option to prepay all or part of the bond, etc.
It’s important that you realize you are stepping into an existing contract when you purchase a bond. Unless you are buying newly issued bonds directly from the borrower, the price you are paying may not be equivalent to the amount the borrower needs to repay at the end of the loan.
The nominal amount the borrower has agreed to repay at the end of the loan is called par value. You might purchase the bond for more or less than par value. You will rarely purchase the bond at exactly par value. That means when it’s time for the borrower to repay, you are often getting back more than you paid for the bond or less than you paid for the bond.
You will often hear people talking about interest being paid on the bond, but you want to factor ultimate repayment value into your return calculation as well.
This is part of a mini-series called The Ultimate Guide to Understanding Bonds. Check out the rest of the series here. If you are still looking for a solution to track all your investments in one place, my favorite solution is Personal Capital and it is free to use. I review four different investment and expense tracking solutions in more depth here.