We’ve addressed what stocks are, and now it’s time to talk about the other most common financial asset that people buy: Bonds. So what are bonds?
Definition: What are bonds?
A bond is a debt contract. The person who buys the bond, buys the right to receive their money back at some later date, in exchange for regular payments at a specific interest rate. The interest rate on a bond is called a “coupon rate.”
What does this mean?
Bonds are different than many types of consumer loans such as a car loan or a mortgage, but they do have some similarities.
They are similar in that both types of debt have a principal payment and an interest payment. The principal is the face value amount of the original loan. The interest is the additional payments that you make over the course of the loan, in exchange for borrowing the money.
When you purchase a house and take out a mortgage, the bank loans you a certain amount of money. For example, let’s say that you borrow $100,000 to purchase your house. That means that you have a $100,000 mortgage. If you choose a traditional fixed rate, 30-year term mortgage, that means that you will pay back the $100,000 plus interest over the course of the 30 year period. Each month you pay the same amount as the month before, and after 360 payments (30 years*12 months) you will have paid back the debt. Each payment is a combination of principal plus interest. At the beginning of the loan period, the principal portion is very small, but grows larger as time goes on.
The difference is that bond and mortgage principal are paid back in separate ways. With a mortgage you pay back the principal each month slowly over the course of the entire loan. However, with a bond the principal is only paid back at the very end of the loan.
Let’s take a look at an example of a $100,000 bond with a 5% coupon rate. This bond will have a 5 year term with annual payments. Most bonds make payments quarterly, twice a year, or annually, or in special cases, don’t make regular interest payments at all.
In our example, the cash flows are shown below. The payment in red is money that you pay, while the payments in black are money that you receive.
Year 0: $(100,000) (Your payment to purchase the bond)
Year 1: $5,000
Year 2: $5,000
Year 3: $5,000
Year 4: $5,000
Year 5: $105,000 (Principal + Interest)
Bonds are simply debt contracts that can be thought of like you would a car loan or a home mortgage. However, they have slightly different payment terms. Car loans or mortgages are amortized, meaning that you pay back interest and principal at the same time. Bonds only pay back the principal at the very end of the bond term. This is very important to remember if you choose to purchase individual bonds, because you will have to reinvest the principal payment once the bond expires. Most people however purchase bonds through bond mutual funds and the mutual fund manager takes care of that for them. For those of you who choose to become DIY Investors, we’ll address strategies for reinvesting bond principal repayments, and managing bond expiration ladders in future posts.