What Are Bonds in Simple Terms: Coupon, Face Value, Yield

A bond is a debt security under which the issuer borrows money from an investor and undertakes to return the face value by the maturity date, paying interest along the way. Put simply, by buying a bond you lend money to a company or a government at a known interest rate in advance. It is an instrument of predictable income, not a bet on a rise in price.

Bonds are the calm part of the market, and that is exactly why fans of quick moves often underrate them. For me bonds are a yield benchmark, not a field for trading. But understanding how they work is useful for anyone who wants to see the whole market and not only its speculative part. Let's go through it in order: what they are, how they work and how reliable they are.

In this article we'll cover:

• a bond is a debt security: you lend to the issuer, and it returns the face value by the maturity date;
• along the way the issuer pays a coupon, an agreed-in-advance interest on the debt;
• bonds can be government and corporate, and each has its own level of risk;
• in my experience a reliable bond does not mean a risk-free one: default risk and interest-rate risk remain.

Let's start with what a bond even is and how it differs from a stock.

What Bonds Are

A bond — a debt security under which the issuer borrows money from an investor and undertakes to return the face value by the maturity date, paying interest along the way in the form of coupons.

Put simply, a bond is a formalised debt. A company or a government, called the issuer, needs money and borrows it not from a bank but from many investors by issuing bonds. By buying such a security, you become a creditor: you are promised the return of the sum lent by a certain date and interest for the use of the money. In this a bond differs fundamentally from a stock: a stock is a share in a business and a right to part of the profit, while a bond is a debt with fixed terms. How owning stocks differs from speculative trading I cover in the piece on trading and investing.

In short: a bond is a formalised debt: you are the creditor, promised the return of the face value by maturity and the payment of a coupon; unlike a stock it is a debt with fixed terms, not a share in a business.

How Bonds Work: Face Value, Coupon, Yield, Maturity

A bond has several key parameters. The face value is the sum the issuer will return to the holder on the maturity date, usually the base value of the security. The coupon is the interest the issuer pays for the use of your money, usually once every half-year or year. The maturity date is the day the debt is returned and the bond ceases to exist. The yield is the final return taking into account the purchase price and the coupons: if you buy a bond below face value, the yield will be higher than the coupon rate, and vice versa. An important point: a bond's market price is inversely related to the central bank's rate. When the rate rises, new issues offer a higher interest, and old securities with a low coupon fall in price. How central bank rates affect the market overall I cover in the piece on fundamental analysis.

A cash flow similar to a coupon exists for stocks too, only there it is not guaranteed and is called differently. How payouts on a bond differ from payouts to shareholders can be seen in comparison with dividends.

In short: a bond's price is inversely related to the rate: when the rate rises, new issues pay more and old securities with a low coupon fall in price; buy below face value and the yield is above the coupon.

Types of Bonds and Their Risks

By type of issuer bonds are divided into government and corporate. Government ones are considered the most reliable, because the treasury stands behind them, but their yield is usually lower too. Corporate ones offer a higher interest but carry more risk, since a company can run into problems. The main risk of a bond is default, the situation when the issuer cannot return the debt or pay the coupon. The second risk is a change in the rate: when rates rise, your bond with a fixed coupon loses value if you decide to sell it before maturity. So the rule is simple: the higher the promised yield, the higher the risk too, and an extra-high interest is a reason to be wary rather than glad.

I consider bonds an investor's instrument for predictable income, not a trader's field. In my experience they are good for exactly what makes them uninteresting to a speculator: they give a calm fixed flow with no sharp moves, which is what I work by. So for me bonds are rather a benchmark of risk-free yield, a reference point I compare the return from active trading against, than an asset to trade. And it is important not to confuse reliable with risk-free: government securities carry interest-rate risk, corporate ones default risk too, and an extra-high interest is always payment for elevated risk. This isn't investment advice, it is how I treat this instrument: bonds are the calm base of a portfolio, not a source of thrill. How macroeconomics and rates set the backdrop for all markets I cover in the course section on fundamental analysis.

In short: reliable does not mean risk-free: government securities still carry interest-rate risk, corporate ones default risk too; an extra-high yield is payment for risk, not a gift.