What is a bond? · RiskAtoms Academy

By the end you will be able to

1Identify the issuer, face value, coupon and maturity of a bond, and the other terms on its term sheet.
2Define a bond as a tradable loan and name the parties involved.
3Write out the cash flows of a simple fixed-coupon bond.
4Explain why issuers issue bonds and why investors buy them.

Why it matters

Governments and large companies raise much of their long-term borrowing by selling bonds. The bonds in issue around the world are worth more than all the world's listed shares put together. To understand how the financial system is funded, and where its risks sit, start with the bond.

Core explanation

A loan, cut into pieces and made tradable

Picture a company that wants to build a new factory. The factory costs far more than any one lender would want to hand over. So the company cuts its borrowing into thousands of equal slices of £1,000 each, and sells each slice to a different lender. Each slice is a bond.

“Tradable” means a lender who needs their money back early does not have to ask the borrower. They can sell the bond to someone else.

The parties. Three kinds of party appear in almost every bond:

The issuer is the borrower: a government, a company or a bank.
The bondholders are the lenders. They own the bond and receive its payments.
A trustee or a paying agent sits in the middle. The trustee watches out for the bondholders; the paying agent moves the money.

The term sheet. A bond's main terms are listed on a short document called a term sheet. A longer legal document, the prospectus, gives the full detail. Click each line below to see what it tells you.

Click a lineTerm sheet: Example plc 4% 5-year bond

Issuer

Who is borrowing, and so who must pay. Example plc is a made-up company.

In the cash flows: Every payment comes from the issuer, passed on by the paying agent.

Four of these terms do most of the work. The face value is what gets repaid. The coupon rate sets the interest; each interest payment is called a coupon. The maturity says when it all ends. And the issuer says who owes the money.

Bond, bank loan or share? A bank loan has one lender, and its terms are agreed in private. A bond has many lenders and can be traded. A share is different again: it is a slice of ownership, not a loan, and the company promises it nothing. A bond is a fixed claim: the issuer promises set payments on set dates. If the issuer fails, bondholders are paid before shareholders. They may not be paid in full, but they stand ahead in the queue.

Sort itBond, bank loan or share?

4 items

You lend to a government alongside thousands of other investors, and can sell your piece next week.
A company agrees a private five-year borrowing with a single lender.
You own a small slice of a company and vote at its annual meeting, but are promised no payments.
You are promised 3% a year for ten years and your money back at the end, and the investment is traded in the market.

A fixed claim is not a guarantee. The issuer promises to pay, but it might not manage to. That risk is credit risk, the subject of L1.4.07. A bond's market price can also move after issue, because interest rates change. That is covered in L1.4.03 and L1.4.06.

Why issuers sell bonds. Bonds let an issuer borrow for many years in one go, so they lengthen its tenor. And selling to many investors means the issuer does not depend on a single bank.

Why investors buy them. The payments are fixed in advance, so the investor knows what to expect if the issuer pays. And bonds can match long-term promises: a pension fund must pay pensions many years from now, and a bond that pays on known dates far into the future suits that need. L1.2.03 and L1.2.05 show why insurers and pension funds hold so many bonds.

The formal version

The cash flows of a fixed-coupon bond follow from four terms. We use the same letters as the rest of this module: $F$ is the face value, $C$ the coupon paid each year, $T$ the number of years to maturity, and $m$ the number of coupons a year.

C = \text{coupon rate} \times F

Each payment is $C/m$ , and there are $n = m \times T$ of them. The last one also repays the face value:

\begin{aligned} \text{payments } 1 \text{ to } n-1 &:\ \frac{C}{m} \\[4pt] \text{payment } n &:\ \frac{C}{m} + F \end{aligned}

If you hold the bond to maturity, the total cash you receive is:

\text{Total} = n \times \frac{C}{m} + F = C \times T + F

Coupons that stay the same for the whole life of the bond make it a fixed-coupon bond. L1.4.02 covers the other kinds.

Try it

Set up a bond and watch its payments appear. Start with the term sheet above: £1,000, 4%, 5 years, paid once a year. Then switch to two coupons a year: the bars halve and double in number, but the total stays the same.

Try itCash flow builder

Face value

Coupon rate (a year)4.00%

Years to maturity5

Coupons a year

Each coupon

£40.00

Payments5

Final payment£1,040.00

All coupons£200.00

Total received£1,200.00

Every payment, in time order coupon face value repaid

The last bar towers over the rest: most of the money comes back on one day, at maturity.

Worked example

The cash flows of Example plc's bond

Take the term sheet above. The investor buys at the issue price of 100, so pays £1,000, and holds the bond to maturity. Try each step before revealing it.

Annual coupons

Step 1 of 4

1
The coupon
4% × £1,000 = £40 a year, paid once a year.

The same bond with two coupons a year

Step 1 of 3

1
Each coupon
£40 ÷ 2 = £20, paid every six months.

After issue, the bond can be sold. The buyer receives the rest of the cash flows, and the price they pay may differ from £1,000. L1.4.03 shows why.

Regulatory lens · looking ahead

No rules apply yet. Banks and insurers hold very large bond portfolios, and later levels cover the rules that govern them: the liquidity coverage ratio for banks (L4.5) and Solvency II for insurers (L4.6).

Sparks

SparkWhy is it called a coupon?

Bonds used to be printed certificates with a sheet of small slips attached. On each payment date the holder clipped off one slip, the coupon, and handed it in to collect the interest. The certificates have gone, but the word stayed.

SparkA bond from 1648 that still pays

In 1648 a Dutch water board borrowed money to maintain a river dyke and issued a bond with no maturity date. Yale University now holds it, and the water board's successor still pays interest when it is presented. A bond lasts as long as its issuer keeps paying.

Key takeaways

A bond is a tradable loan: many lenders (bondholders) lend to one borrower (the issuer).
The term sheet gives the issuer, face value, coupon rate, coupon frequency, maturity and issue price.
Each coupon is the coupon rate times the face value, divided by the number of payments a year. The last payment adds back the face value.
Bondholders have a fixed claim and are paid ahead of shareholders if the issuer fails, but payment is not guaranteed.
Issuers use bonds to borrow for longer and from more lenders. Investors buy them for predictable income and to match long-term promises.

Reaction

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Glossary

Bond: A tradable loan: an issuer promises fixed payments to bondholders and repays the face value at maturity.
Issuer: The borrower that sells the bond, such as a government, a company or a bank.
Bondholder: The lender who owns the bond and receives its payments.
Trustee: An independent firm that looks after the bondholders' interests and checks the issuer keeps to the bond's rules.
Paying agent: A bank that passes each payment from the issuer to the bondholders.
Face (par) value: The amount the issuer promises to repay at maturity, and the base for working out coupons. Also called par value.
Coupon: One interest payment made to the bondholder.
Coupon rate: The yearly interest, shown as a percentage of the face value.
Maturity: The date on which the bond ends and the face value is repaid.
Tenor: The length of a borrowing, from the start to the date it must be repaid.
Term sheet: A short document that lists a bond's main terms.
Prospectus: The long legal document that describes the bond, the issuer and the risks in full.

Deep Dives & Origins

Deep Dives

Frank J. Fabozzi and Francesco A. Fabozzi, Bond Markets, Analysis, and Strategies, 10th edition, Pearson, 2021, chapter 1. Beginner.

Origins

Frank J. Fabozzi and Francesco A. Fabozzi, Bond Markets, Analysis, and Strategies, 10th edition, Pearson, 2021.
SIFMA, Capital Markets Fact Book (annual): global bond and equity market size.
Beinecke Rare Book and Manuscript Library, Yale University: the 1648 Lekdijk Bovendams water board bond.

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