Many investment professionals advocate holding a diversified portfolio comprised of a mix of stocks, bonds and cash. However, when considering appropriate investment vehicles, some self-directed traders tend to overlook bonds completely. (But obviously you’re not one of them or you wouldn’t be reading this. So bully for you.)

So what’s a bond, anyhow? Excellent question. We’re glad you asked.

When individuals need to borrow money, for example to buy a home, they’ll typically go to a bank and take out a mortgage. But when large corporations, municipalities, governments and other such entities need vast sums of money to build a new manufacturing plant, create a new mass transit service, or fund large-scale research, they can’t just walk into their friendly neighborhood bank branch and get the cash they need. Since banks alone can’t meet their high borrowing requirements, such entities sometimes choose to raise money by issuing bonds to the general public.

Bonds are a type of investment known as a “debt security”. You can think of the bond itself as a sort of IOU, because when you buy a bond you’re actually loaning money to the entity that issued it. In exchange for the loan, you’ll be paid a specified rate of interest over a set period of time. When the bond “matures” or “comes due” you’ll presumably get back its full face value. (We say “presumably” here, since there’s always the risk that the bond issuer won’t be able to pay you back. More on that later.)

There are several different kinds of bonds, each with a different set of risks and rewards, depending on the issuer. Types of bonds available include U.S. federal government securities (collectively referred to as “Treasuries”), municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds. All types of bonds work according to the same basic principle: interest paid in exchange for a loan until the loan is repaid.

Anatomy of a bond

All bonds have these three characteristics: face value, coupon, and maturity date. A fourth characteristic, duration, is a calculated value which helps you assess interest rate risk. We’ll define each characteristic, tell you how they enable bonds to serve as a source of “fixed income” for a set period of time, and give you an example showing how it all comes into play.

Face value, or “par” for the course

The face value is the amount of money you’ll receive from the issuer when a bond reaches its maturity date. Interestingly, the face value is not necessarily the amount of money you’ll pay for the bond, known as the principal. Occasionally you may see these terms used interchangeably, but they are not the same.

Bonds are issued with even-denomination face values. Much of the time the face value, or “par value,” will be $1,000, but it may also be some other figure like $5,000, $10,000, or $20,000. Bond prices are expressed in units of $100, which you can think of as representing a percentage of the face value. For example, if a $1,000 bond is trading in the secondary market at a price of $98.475, you’ll pay $984.75, or 98.475% of the bond’s face value. If a $5,000 bond is trading at a price of $98.475, you’ll actually pay $4923.75 for the bond — once again 98.475% of the bond’s face value.

Some bonds trade for more than the face value (at a “premium”), while others trade for less than face value (at a “discount”). In fact, the value of a bond will fluctuate throughout its life span depending on several factors like market conditions, prevailing interest rates and the issuer’s credit rating.

A bond’s face value is also frequently referred to as the “par value” of the bond. These terms mean the same thing, so don’t get confused, confounded or discombobulated when you run into them being used interchangeably. Just remember, par value equals the face value of a bond.

Coupon

The coupon is the amount of interest paid on the bond. It’s called the coupon because bonds used to feature actual coupons that you would tear off and redeem to receive the interest payments. For the most part physical coupons are a thing of the past, and now interest payments are almost always handled electronically.

If a bond has a face value of $10,000 and the coupon is 8%, then the holder will receive $800 interest every year over the life of the bond. Most bonds pay the coupon every six months, but some may pay monthly, quarterly or annually. Still others will pay compounded interest along with the face value on the date the bond matures. Whenever you buy a bond, make sure you know the exact terms of the coupon and when it will be paid.

Bonds with shorter life spans usually pay lower rates of interest than long-term bonds. That’s because short-term bonds tend to have lower risk. Bonds with longer life spans usually pay higher interest to compensate the buyer for potentially greater fluctuations in the general marketplace, changes in prevailing interest rates and risks associated with the issuer’s ability to pay the coupon or repay the bond’s face value at maturity.

Coupons allow you to reap the rewards of your money working for you, instead of you working for your money. When you reinvest coupons, that’s the equivalent of getting your money to work overtime. This is also known as the power of compounding. Although each coupon may seem too small to invest on its own, the amount accumulated over the course of a year can be significant. If you place these coupon payments in a savings account, you will likely have enough funds to make another investment. Consider reinvesting coupons on an annual basis.

Maturity date

The maturity date is the day when the issuer has promised to repay the holder the full face value of the bond. Maturity dates of bonds typically range from one to 30 years from the date of issue, but it’s not unheard of for bonds to have a life span of as little as one day or even as long as 100 years.

It’s important to note that when you buy a bond, you’re not stuck with it until the maturity date. Like most other securities, bonds can be bought or sold on the open market at any time during their life span. Bonds with longer maturities are more sensitive to changes in interest rates.

Bond duration

This is a calculated value indicating how much a bond’s price may change with result to changes in interest rates. The higher the duration, the more sensitive the bond’s price is to interest rate fluctuations. Calculating duration is based on its time-to-maturity, coupon payments, the redemption value of the bond compared to purchase price, and when all financial payments occur. Duration is expressed in years.

The meaning of “fixed income”

Bonds are often called “fixed income” investments because the amount of money you receive and the dates on which you receive payments are specified in advance, or “fixed.” Typically, fixed income securities are regarded as having less risk than stocks. However, like all forms of investment bonds do involve risk.

An example of a bond

Imagine a manufacturing firm called Drive Rite Motors, Inc. needs to raise capital to expand their facility and buy new equipment. To raise the funds, they decide to issue 10-year bonds with a face value of $1,000 and a 6% coupon payable semi-annually.

Before buying Drive Rite Motors bonds, you’d want to be reasonably certain the firm would remain solvent for the ten-year life span of the investment. That way, they’ll be able to pay the coupon over time, and ultimately return the bond’s face value to you on the maturity date. Assuming that to be the case, let’s say you bought ten Drive Rite Motors bonds with an issue date of June 29, 2010. What now?

First, let’s calculate how much you’d receive in interest every year. Ten Drive Rite Motors bonds with a face value of $1,000 each equals a $10,000 initial investment. At a 6% coupon, you’ll receive $600 per year in interest ($10,000 x .06 = $600).

Since the coupon is payable semi-annually, you’ll receive a payment of $300 from Drive Rite Motors every six months ($600 / 2 = $300) on December 29th and June 29th until the bond’s maturity date. Over ten years, you’ll receive 20 payments of $300 totaling $6,000 (20 x $300 = $6,000) until June 29th, 2020. On that day you’ll get the final interest payment along with your entire $10,000 principal investment back from Drive Rite Motors.

Drive Rite Motors

Face value = $1,000 per bond

Initial investment = $10,000 (10 x $1000)

Coupon = 6% paid twice annually

Maturity = June 29th, 2020 Interest equals $600 per year ($10,000 x .06 = $600)

Your fixed income = $300 every 6 months ($600 / 2 = $300)

Over 10 years you get $6,000 in interest payments

That’s 60% of your initial capital. Not too shabby.

Don’t count your coupon payments before they’ve hatched

Some bonds stipulate that the issuer may have the right, but not the obligation, to buy the bond back before the maturity date on a day known as the “call date.” Such bonds are referred to as “callable” or “redeemable” bonds. This feature is in place to benefit the issuer. However, if a bond is called early, that brings some good news and bad news for you as the investor.

The bad news is interest payments cease after the call date. The good news is you’ll get back your principal investment, plus a premium since the call price is usually slightly more than the face value of the bond.

Let’s say Drive Rite Motors’ bonds are callable, entitling them to buy back the bonds on June 29th, 2015 at 102.5% of the face value. If increased profitability from their new equipment and expanded facilities makes it possible to pay the money they borrowed back early, it might make sense to do so instead of shelling out more interest payments over time.

If Drive Rite Motors calls your ten bonds on June 25th 2015, you’ll get back 102.5% of your initial $10,000 investment, or $10,250. From that point, the bonds are considered cancelled and interest payments cease. But look on the bright side: you would have already received $3,000 in interest, plus a $250 premium, and you’re free to invest your capital somewhere else.

Bonds can be “puttable”, too. (You pronounce that like the verb “to put”, not like “putting” in miniature golf.) If a bond happens to be puttable, you retain the right to demand repayment of the face value of your bond. In a rising interest-rate environment, it might make sense to “put” your old bond to the issuer, collect your principal, and reinvest it in a bond with a higher interest rate.

You pay for this perk, however. Puttable bonds tend to pay a lower interest rate than comparable bonds without this feature. You can’t exercise your put any old time you please, either — the issuer usually specifies put dates when you’re free for a limited time to pull the trigger.

In addition, some bond contracts contain clauses allowing the issuer to suspend coupon payments without being considered in default, or have variable interest that can result in a coupon of 0% for some period of time. So keep your magnifying spectacles handy and be sure to read the fine print.

Money in the bank, or junk in the trunk?

There’s always the risk that any bond issuer will become insolvent and default on the bond. In that case, you’d have to engage in some legal wrangling to receive even a small portion of the money that’s owed to you for the coupon and face value of the bonds. Don’t be tempted by the higher interest that comes with high-risk “junk” bonds.

Debt securities vs. equity securities

What’s the difference?

Debt securities like bonds and equity securities like stocks have their own unique sets of risks and rewards. One is not necessarily better than the other. It’s up to you to analyze which securities are right for you and how they fit into your overall portfolio. In fact, chances are you’ll opt to invest in a blend of bonds, stocks and other securities as part of your overall asset allocation plan.

Owner vs. creditor

When you buy stock in a company, you become part owner of that firm. As part owner, you may receive certain privileges, like voting rights and a share of profits via dividends (provided you have purchased a dividend-paying stock).

When you buy a bond, you don’t own any stake in the entity that issued it. You’re simply a creditor. That means you have no say in how the issuing entity is run, and the only return you’ll receive is the interest paid on the bond.

However, as opposed to shareholders, bond owners receive income even if the issuer isn’t performing so well. If you purchase corporate bonds, whether the firm meets with success or difficulty, provided the company stays afloat your rate of return remains the same. So you’re not as exposed to fluctuations in the issuer’s performance. Furthermore, if a firm goes bankrupt, bond owners have a much higher claim to assets than shareholders, who may stand to lose their entire investment.

Asset appreciation vs. asset preservation with income

When you buy a stock, you’re speculating that the stock will increase in value and your assets will appreciate over time. But that’s not necessarily the case. While some stocks outperform the market, others will underperform or even lose their value entirely.

When you buy bonds, you’re preserving your assets because the face value of the bond doesn’t change and (depending on the financial stability of the issuer) you can reasonably expect to be paid back in full on the bond’s maturity date. In addition, you can expect to receive income from interest payments at regular intervals throughout the life of the bond.

Debt vs. equities at-a-glance