Bond Basics: 3 Characteristics of Bonds
NEW YORK (TheStreet) -- Though bonds are astonishingly diverse, the vast majority have a few things in common.
Bonds of all kinds operate on the same basic principle: You as the investor loan money to the bond's issuer, and the issuer pays you interest on the loan, typically twice a year. All bonds have three characteristics that never change:
1. Face value:The principal portion of the loan, usually either $1,000 or $5,000. It's the amount you get back from the issuer on the day the bond matures. A bond's price, which is in constant flux, can be more or less than the face value.
2. Maturity:The day the bond comes due. A 30-year bond, for example, comes due 30 years from the day it is issued. Most bonds mature within 30 years, but maturities can be as short as a year or even shorter. Short-term bonds are usually called notes.
3. Coupon:Because bonds used to come with attached coupons that investors had to clip and redeem for their interest payments (now it's all done electronically), the size of the interest payment is still called the coupon. A bond with an 8% coupon pays 8% of the face value of the bond a year, in two installments. Assuming a face value of $1,000, that's two $40 payments.
...But the Yield on a Bond is Ever-Changing
Another common feature among bonds is that yield is the measure of their value. Think of yields as you would interest rates on a loan. If you're a borrower, you want the lowest possible interest rate. Your lender wants to charge you the highest possible rate.
When you buy a bond, you're the lender, and you want a high interest rate -- or yield.Generally, the higher a bond's yield, the more credit- or interest-rate risk it carries. Just as borrowers pay more if their credit is bad -- or to borrow for a longer term -- you can get a higher yield from a riskier issuer, or if you are willing to lend your money long term. Like their prices, bonds' yields are also in constant flux. When a bond's price rises, its yield drops, and vice versa. Here's why: The yield, in essence, is the annual coupon payment divided by the price. If the price -- the denominator -- gets bigger, the yield gets smaller. If the price gets smaller, the yield gets bigger. The actual formula for the yield is more complicated mathematically, but the upshot is the same: As bond prices drop, the investor who buys that bond for less ends up with a better deal, reflected in a higher yield. Conversely, if a bond's price rises, the investor who buys it at the higher price is getting a worse deal than the investor who bought it when the price was lower. That worse deal is expressed as a lower yield. All of which is why bond investors like to see dropping interest rates. Dropping yields mean rising bond prices.
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