In this post, what are bonds and bond terminology explained, I want to take some time to focus on an area that most people avoid. Most of us only think of stocks when considering investments but bonds are another area where you can make money.
Similar to stocks bonds can be purchased through a bond broker and is one of the ways you can make extra income.
What are bonds?
In simple terms bonds are a form of debt that you and I can invest. Borrowers such as corporations, local government or national government issue bonds as a way to borrow money to fund their operations.
They are held for a specified period at the end of which the organization which issued the bond repay whoever owns the bond. The end of the period is known as the date of maturity.
In the period between the issue date and maturity date, some issuers pay the holder interest usually twice a year. For others, the payment is all done at the maturity date.
I should also point out that once the bond is purchased it can be resold again and again until the date of maturity.
It is therefore common for the final repayment to be made to different bondholders from the original bondholders.
Types of bonds
There are various types of bonds that you can invest in. Some are issued by the government and some by corporations. Below are some of these bonds.
- Corporate bonds: As shown by the name these are bonds that are issued by corporations. Here you can find all sorts of bonds that differ in rates and risk. These are private entities so the risk for default is always there. You, therefore, need to understand the corporation issuing it and any future prospects if you can. If you are not sure then it is advisable to contact a financial adviser before you commit yourself.
- Government bonds: These are issued by governments. The period from issue to maturity can be anything from days to even 30 years. These are considered very safe so your focus should be on the interest to be earned. The other benefit of government bonds is that they could be exempt from tax in some jurisdictions.
- Convertible bonds: These are issued by corporations but are special in that the bondholder or investor in the bond has the option to exchange the bond for a given number of shares of stock. These can be extremely profitable if the stock price rises between the issue date and maturity date.
- Callable bonds: This is another special type of bond that gives the issuer of the bond the option to recall their bond by paying the current price plus a penalty fee. This is usually done when the interest has dropped to such an extent that the penalties are less than the amount saved by issuing bonds at the lower interest rate.
- Puttable bonds: In the case of puttable bonds, the investor has the option to force the issuer to repay the value of the bond minus a penalty. An example would be a situation where interest rates rise so much that your funds stuck in the bonds could be better used in buying other higher-rate bonds. The investor will need to compare the higher interest to be earned in buying new bonds with the penalty he or it will pay.
- Coupon bonds: This is where the issuer makes several payments (coupons) over the course of the life of the bond. The last payment being made upon maturity. This is different from most bonds where the total is paid on maturity.
- Junk bonds: Bonds are called junk when there is a high risk of default. Because of this higher risk, these bonds attract very high-interest rates.
Bonds Terminology Explained
Some terminology on bonds can be rather intimidating to most ordinary people. In the next paragraphs, I will deal with some of the most common terms.
Ask Price: This is the price at which a seller/issuer is willing to sell a bond. This applies to other financial instruments too. The issuer can choose to make the asking price negotiable or firm. If it is negotiable then that means the seller is willing to negotiate on the asking price. Whereas if it is firm it means the seller is not willing to negotiate and won’t change the price.
Bid Price: This speaks of the price at which an investor is willing to buy a bond. This term is also used for other financial instruments other than bonds. It contrasts with the asking price which is the price the seller or issuer is willing to accept when selling the bond.
Spread: This is the difference between the ask price and bid price. Like in all market transactions, the bargaining involves the seller fighting for the buyer to increase their bid price and the buyer fighting to have the asking price reduced. The sale happens when they come to a decision on a price attractive to both sides.
Face/Par Value: This is the amount of money that the seller will pay the bondholder on the maturity of the bond i.e the end of the bond period. It is very important to know that bonds are not always issued at par. They can be issued at a discount i.e. below par value or they can be issued at a premium i.e. above the par value. Also, know that all bonds attract interest.
Maturity: This is the day when the bond will be repaid by the issuer.
Issuer: This is the organization that initially sells the bond and it is them that will repay the bond. As mentioned in one of the paragraphs bonds can be resold by the bondholders but the issuer always remains the same.
Price: This is the price at which bonds are selling.
Price change: This looks at the change in price in the bond when compared to a previous period.
Yield: This is the rate of return or in layman’s language the interest the buyer will experience in buying a bond at a particular price in a given year.
Yield change: This refers to the change in the bond’s yield over the previous period.
Yield to maturity: This refers to the total returns if you were to hold a bond, and all coupons, until the maturity date. Remember that bonds can be resold during their life so some people don’t experience the yield to maturity benefits.
Volume: The number of bonds bought or sold during a given period
Credit quality: This is an assessment of the level of risk that a bond issuer (seller) has of defaulting. If the level of risk of default is higher then the issuer has to offer a higher return. All this is assessed by the underwriters of the bond issue. Underwriters guarantee payment in case of default