Bond Definition

What is a Bond?

TECHNICALLY SPEAKING, a bond is a loan and you are the lender. Who's the borrower? Usually, it's either the U.S. government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate -- to fund the federal deficit, for instance, or to build roads and finance factories -- so they borrow capital from the public by issuingbonds.

Now for a little bond-speak. When a bond is issued, the price you pay is known as its "face value." Once you buy it, the issuer promises to pay you back on a particular day -- the "maturity date" -- at a predetermined rate of interest -- the "coupon." Say, for instance, you buy a bond with a $1,000 face value, a 5% coupon and a 10-year maturity. You would collect interest payments totaling$50 in each of those 10 years. When the decade was up, you'd get back your $1,000 and walk away.

A key difference between stocks and bonds is that stocks make no promises about dividends or returns. General Electric's dividend may be as regular as a heartbeat, but the company is under no obligation to pay it. And while GE stock spends most of its time moving upward, it has been known to spendmonths -- even years -- going the other way.

When GE issues a bond, however, the company guarantees to pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity, you know exactly how much you're going to get back (in most cases, anyway. We'll discuss some exceptions later). That's why bonds are also known as "fixed-income" investments -- they assure you asteady payout or yearly income. And although they can carry plenty of risk (we'll discuss why in our How Bonds Behave lecture), this regular income is what makes them inherently less volatile than stocks.

When Yield Goes Up, Price Goes Down

ALL RIGHT, we might as well dive right into the yield and price mess. Since the first bond hit Wall Street, it's the thing that has most confusedbeginning investors. You've probably heard the mantra at least once before: When yield goes up, price goes down, and vice versa. But if you're like most people, you haven't the faintest clue why.

Well, here goes...

So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that, but many others -- including the pros -- buy and sell them on theopen market before they reach maturity. Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to sell a bond for "par," or 100% of its face value.

We'll explore what drives price changes in the next lecture, but for now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and itsultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6% ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal -- you're getting the same payout for $400 less.OK, So What Does 'Yield' Mean?

Yield -- a bondspeak standard -- is a figure that captures this change in value. It's the percentage return your bond investment promises at any given price.

In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price. When you buy a bond for face value, the yield is simply the coupon, or interestrate. But when the price fluctuates, the yield grows or shrinks to compensate in either direction.

Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price...