In its simplest and most common form, a bond is a security that pays its holder a fixed sum on a regular schedule for a fixed term.
Bonds are debt securities. Bond investors are lenders; bond issuers are borrowers. To issue a bond is to borrow money from investors for a fixed term at a fixed interest rate. At the end of the term, the issuer returns the principal portion of the loan.
Principal is typically $1000 per bond, or some multiple thereof. This is also known as a bond's face value.
A typical bond pays interest on its face value, or principal, twice a year at a rate called its coupon. A $1000 bond with a 6% coupon pays $60 a year in two installments. This is why bonds are also called fixed-income securities.
A bond's coupon rate is a function of two things -- its term and its credit quality.
Longer-term bonds typically have higher coupons to compensate the investor for the risk that interest rates will rise before the bond matures. This is interest-rate risk. Most bonds mature in 30 years or less.
Credit quality refers to the issuer's ability and willingness to pay interest and repay principal on schedule. Most bonds carry ratings (triple-A is the highest) indicating their credit quality. Low-quality bonds carry large coupons to compensate investors for the risk that the issuer will default, or fail to make timely payments. This is credit risk.
There are three main classes of bond issuers: Treasury securities are issued by the federal government; municipal bonds are issued by states and local governments; and corporate bonds are issued by companies. Other types of bonds include high-yield bonds, agency securities, mortgage-backed securities and asset-backed securities. Except for municipal bonds, all the other types are collectively referred to as spread product.
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