Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.
Even casual investors have heard of bonds. Next to equities or shares, they are probably the best-known type of investment asset. But how much do you understand about how bonds work? How much money can you expect to make from investing in one? Do you know what a coupon is? Or what the yield is?
If you don't know, don't worry, read on.
First, a few basics. A bond is a loan. Generally to a company (these are called corporate bonds) or a Government (these are called sovereign bonds, for example, UK Gilts). Bonds are usually for a fixed term or in other words, the bond issuer promises to pay you back on a given future date (sometimes there is a range of dates with special rules but we'll ignore complications like that for this article).
The money paid for the bond is called the principal. And in return for you lending them the principal, the bondholder will pay you some interest at regular intervals. This is called the coupon.
What Is a Coupon?
The coupon is the interest paid to the bondholder by the bond issuer. This is similar to getting paid interest on your saving account with a bank (you are like the bondholder in this situation) or paying interest on your overdraft (here you are like the bond issuer).
The coupon is usually given as a percentage of the principal or face value of the bond and is the amount of interest paid in a year. For example if you have a $100 face value which has a 5% coupon the you would be paid $5 in coupon payments. Generally speaking bonds are paid semi-annually (in other words every six months). So you would be paid in two lots of $2.50.
Return of the Principal
At the end of the term of the bond, the issuer will pay you back the face value, aka the principal, sometimes together with a final coupon payment.
This means if you have a $100 bond, it will pay you back $100. This is not necessarily the same as the price you paid for the bond, which will take into account current interest rates.
Learn about investing in different types of bonds here:
The Yield Will Vary
But the face value is not the same as the market price. The market price of the bond can go up or down. You are unlikely to pay the face value of the bond.
This means that the actual return you get is not the coupon rate (unless by pure chance the market price is the same as the face value). The yield (strictly the gross redemption yield, sometimes people use some other yield calculations.) is the effective return you would get if you hold the bond until the end of the term based on the current price of the bond. The yield could be greater or smaller than the coupon.
The yield is affected by the return available on other investments and by the probability that the issuer will go bust and be unable to pay you back the amount you promised.
Other Things to Think About
All these numbers like the coupon and the yield ignore the possibility that the bond issuer might go bust and not pay you back as much as they promised. Bondholders will get paid before shareholders, but that doesn't help you if there is not enough money left to pay back the bond in full - or at all.
Don't forget that if a bond has a high yield that is usually because it is risky. As a general rule higher return investments come with higher risks, so make sure you investigate and understand the risks to your investment.
You might need to consider the tax status of your payments - these might be different for coupon payments, principal, and/or resale price if you cash in early. It depends whether they are treated as income or capital gains where you live. And also some bonds have special tax exemptions (some Government issued bonds do).
Also, you will generally not be able to buy corporate bonds directly as a retail investor, you will have to buy either through a brokering platform or buy a fund that invests in bonds.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.