You may think of borrowers and lenders in a traditional sense as the relationship that exists between, for example, a bank as the lender and an individual as the borrower. But in the world of bonds, this relationship takes an unconventional turn. Although you’re not an institutional lender, you can become an individual lender if you’re a bond investor. A bond issuer is also the borrower, and a bondholder becomes the lender.
What Is a Bond?
As a type of IOU, a bond represents a debt obligation that the borrower is obligated to repay to the investors. When an entity issues a bond, it’s essentially asking for a loan through the money that the bond raises, and the investors who purchase the bond are extending the loan. Similar to conventional loans, bonds also pay interest to its lenders, depending on the specific terms of each bond.
Bonds Vs. Loans
Although bonds are a type of loan, they are structured a little differently than, for example, a consumer loan. While you probably make monthly payments to pay back your consumer loan, a borrowing bond issuer typically repays the entire principal balance in full on a certain maturity date while making periodic interest payments.
Other lenders characteristically are “big” players such as banks and other financial institutions. But in bond transactions, “big” players (including companies, corporations and even governments) become the recipients of the loan and the “little guys” are the lenders.
Who Are Bond Issuers?
Governments have issued bonds as early as 1812, when the City of
Who Are Bondholders?
Bondholders are investors who purchase bonds – they “hold” the bonds until the issuing entity repays their investment. But “hold” is a relative term in today’s electronic age. Most bond issuers do not actually issue paper bonds that an investor can literally hold, but instead they issue bonds electronically, for investors to hold virtually. Investors can purchase, manage and redeem their bonds online without leaving their homes or offices.
Evaluating Conduit Bonds
Some bond issuers are called “conduit issuers” because they issue bonds that benefit a third-party. For example, a city (the conduit issuer) may issue bonds for a hospital (the conduit borrower). There’s a measure of risk for investors with conduit financing because if the bond defaults, the conduit issuer is typically off the hook to guarantee the bond.
Exploring Bond Types
Different types of bond cover a diverse spectrum in the bond market that includes borrowers as large as the federal government to a small local school district.
Examples of bond types include:
“Government” includes different entities such as the federal government, a state, a city or a municipality. At the federal level, a government bond is called a “sovereign” debt, which is funded by taxes or government-printed currency. Sovereign debt is divided into classes, according to when each debt security matures. Bonds include bills, which mature in less than one year; notes, which mature between one and 10 years; and bonds, which mature in more than 10 years.
These bonds represent another type of government bond. Commonly called “munis,” or “city bonds” if the issuing government is a city, these bonds may also be issued by government agencies. Compared to federal bonds, municipal bonds typically carry a higher investing risk. Although it’s uncommon, cities sometimes go bankrupt and default on their debt obligations. On the up side, however, municipal bonds are generally exempt from federal tax and often exempt from state tax, too.
The corporate sector represents a large piece of the overall bond market. Generally speaking, corporate bonds pay higher yields than most government bonds because there’s a greater likelihood that a corporation will default on its debts compared to a government.
Divided according to length-to-maturity classes, a corporation’s bond is a short-term corporate bond (maturing in less than five years), an intermediate corporate bond (maturing in five to 12 years) or a long-term corporate bond (maturing in more than 12 years).
Another type of corporate bond is a convertible bond, so-named because investors have the option to convert the bonds on a certain date to common stock shares. Some corporations offer callable bonds, which allow the corporation to “call” (redeem) their bonds before they mature and reissue them at a lower interest rate.
Asset-backed securities, also known as “ABS,” are issued by banks and other financial participants. A bank may bundle the cash flows from a pool of assets and offer these ABS bonds to investors. A common source of ABS is a bank’s mortgage-loan pool that the bank offers as mortgage-backed securities.
The Securities and Exchange Commission notes that municipal bonds typically fall under two categories:
- General obligation bonds. These bonds rely on the “full faith and credit” of their issuers without being secured by any assets. Government issuers, however, have full authority to tax their residents in order to pay their bondholders.
- Revenue bonds. These bonds do not rely on a government’s authority to tax residents; instead, the bonds are paid from the revenue that the bonded project generates.
Examples of Bonds
You may be familiar with the term “bond referendum” that appears on your city’s ballot. These bonds require voting approval before issuance. Bond offerings – requiring voter approval or not – include funding for projects such as improving a state’s infrastructure, including highways and bridges; financing a company’s operations; building hospitals, schools and libraries; and repairing water/wastewater facilities.
Bond Maturity Dates
Different types of bonds have different maturity dates, which are the dates on which the bond issuer repays its investors their full principal amount. Bonds may be term bonds or serial bonds, depending on how their maturities are structured.
Term bonds represent bonds from the same issue that have the same maturity dates. Term bonds stretch further into the future than most serial bonds, typically from 20 to 30 years. Serial bonds are groups of bonds that are bound together with different bonds maturing at different times during the series. The series typically spans anywhere from a year to 20 years.
Advantages of Bonds
Bonds carry certain risks, as all investments do, but they also have certain rewards that include:
- Some bonds are federally tax-exempt, and they may also be exempt from state taxes.
- Bonds are generally “safer” investments than stocks because bonds don’t typically experience the daily highs and lows that stocks do (an exception is “junk bonds,” which are riskier than other bond types).
- Conservative investors find bonds to follow a more predictable route that they regard as more secure than other types of investments.
- The interest rate paid on bonds is usually higher than the rates that banks pay on savings accounts.
Disadvantages of Bonds
Some of the risks associated with investing in bonds include:
- Credit risk. Bond issuers potentially can default on payments if they experience financial difficulties. Investors can check an issuer’s credit rating before purchasing bonds, although a current good credit rating is not a guarantee of continued financial health.
- Call risk. If a bond issuer “calls” a bond (repays it before the maturity date), an investor’s rate of return will be less than expected.
- Inflation risk. As market interest rates rise, bonds experience lower market value.
Video of the Day
- Investopedia: Bond Basics - What are Bonds?
- U.S. Securities and Exchange Commission: Bonds
- The GMS Group: The Story Behind Municipal Bonds
- TreasuryDirect: Brief History of the Savings Bond Program
- Investopedia: Conduit Issuer
- Investor.gov: Municipal Bonds
- Municipal Securities Rulemaking Board: Bond Referendum
- Investopedia: Bond Basics - Different Types of Bonds
- MSRB: Facts About Municipal Bonds