Bond
What is Bond?
A bond is a debt security in which an investor lends money to a government or company in exchange for periodic interest and repayment at maturity.
Bond prices and interest rates move in opposite directions: when rates rise, existing bond prices fall. Central banks buy and sell government bonds in open market operations to change the money supply. Bonds are generally lower-risk than stocks.
Bond: a worked example
Consider a bond promising a single payment of 840 dollars one year from now, with no coupon. If comparable investments yield 5 percent, the bond is worth 840 ÷ 1.05 = 800 dollars today, and a buyer at that price collects 40 dollars, which is 40 ÷ 800 = 5 percent. Suppose market interest rates then jump to 12 percent. The same promised 840 dollars is now worth only 840 ÷ 1.12 = 750 dollars, because a buyer needs the gap to deliver 12 percent: 90 ÷ 750 = 12 percent. Nothing about the bond itself changed, yet an investor who paid 800 dollars can sell for only 750, a capital loss of 50 dollars. Rates up, price down, with the size of the fall set by how far rates moved.
The mistake students make with bond
Rising interest rates get read as good news for existing bondholders, on the reasoning that bonds pay more when rates go up. A bond already issued has a fixed payment written into it that never rises. The only way its return can match better offers elsewhere is for its price to fall, so higher rates hand current holders a capital loss. Holding to maturity avoids selling at 750, since the issuer still pays the promised 840, but that holder stays locked into 5 percent while new buyers earn 12.
Bond questions
What is the difference between a bond's coupon rate and its yield?
The coupon rate is fixed at issue and calculated on the face value, so a bond with a 500 dollar face value and a 5 percent coupon pays 25 dollars a year for as long as it lives. The yield is calculated on the price an investor actually pays. Buy that same bond secondhand for 400 dollars and the unchanged 25 dollar coupon works out at 25 ÷ 400 = 6.25 percent, so yield is the number to compare across bonds.
What happens to the money supply when the central bank buys bonds?
Buying bonds increases the money supply. The central bank pays for the securities by crediting bank reserves, banks then hold excess reserves to lend, and that lending multiplies deposits through the banking system. Bond prices get bid up along the way, so interest rates fall, encouraging investment and interest sensitive spending. Open market purchases are the standard expansionary tool.
What is the difference between a bond and a stock?
A bond is a loan, and a stock is ownership. Bondholders are creditors entitled to fixed interest payments and repayment of principal on a set date, and they get paid before shareholders if the issuer fails. Stockholders own a slice of the firm, may receive dividends, and rise or fall with its profits without any promised repayment. Bonds usually carry lower risk and lower expected return.
Related terms
Common comparisons
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