Bond (finance)

A bond is a financial security that acts as a formal loan. In this arrangement, one party is the issuer, who is the debtor. The other party is the holder, who is the creditor.

The issuer is legally obliged to provide cash flow to the creditor. This cash flow usually includes interest payments and the repayment of the principal. The principal is the original amount of money borrowed. The interest is often called a coupon.

Bonds allow borrowers to access external funds for long-term investments or government spending.

Bonds function through a specific set of rules and timelines. The issuer must pay interest at fixed intervals, such as semiannually or annually. The length of the loan is known as the maturity, term, or tenor. On the maturity date, the issuer must repay the nominal amount, also called the face amount or par value. Most bonds have a term of less than 30 years. However, some rare bonds are irredeemable, meaning they are perpetuities with no maturity date.

Debt instruments with terms shorter than one year are usually called money market instruments instead of bonds.

There are several distinct types of bonds used in the global economy. Municipal bonds are issued by local governments, while corporate bonds come from companies. Government bonds are issued by national authorities. In the United States, Treasury securities are categorized by their maturity length. Short-term securities are called bills, which mature in under one year. Medium-term securities are called notes, lasting between one and ten years. Long-term securities are called bonds, lasting between ten and thirty years.

These different categories help investors choose how long they want to lend their money.

Issuing bonds involves different processes depending on the borrower. One common method is underwriting, where a syndicate of banks or securities firms buys the entire issue. The underwriters then resell the bonds to investors. These firms take the risk if they cannot sell the bonds to end investors. Bookrunners manage this process by contacting investors and advising on timing and price. In contrast, government bonds are often issued through an auction. In some cases, a "tap issue" occurs, where a government issues bonds over time at a fixed price.

Understanding the difference between bonds and stocks is vital for finance. Stocks represent an equity stake, which means the holder is an owner of a company. Bondholders hold a creditor stake, meaning they are simply lenders. This distinction creates a specific hierarchy during bankruptcy. Bondholders have priority over stockholders and are repaid in advance. However, bondholders still rank behind secured creditors. This structure provides a level of protection for those lending money to a corporation.

Investors often look at the yield to understand their potential return. The yield is the rate of return received from the investment. The current yield is the annual interest payment divided by the market price. The yield to maturity is a more complex estimate of the total return. It assumes the investor holds the bond until the maturity date and reinvests all interest payments.

The quality of a bond also matters, as it indicates the probability of a default. High-yield bonds, sometimes called junk bonds, are riskier and rated below investment grade. Because they are riskier, investors expect a higher yield to compensate for that risk.

Bonds are governed by formal legal documents and can have special features. An indenture is the formal agreement that establishes the terms of the bond issue. Within this document, covenants are clauses that specify the rights of bondholders and the duties of issuers. Some bonds include embedded options, such as callability or puttability. A callable bond allows the issuer to repay the debt before the maturity date. A putable bond allows the holder to force the issuer to repay the debt early. These features allow for flexibility in how debt is managed over time.