How bonds work

A bond is a loan that has been turned into a tradable security. The issuer — a government, a bank or a company — borrows a fixed amount, promises to pay interest (the coupon) on set dates, and repays the amount borrowed at maturity. Investors can sell the bond to someone else at any time before then, at whatever price the market will pay.

Because the promised cash flows are fixed, everything about a bond's value comes from two questions: what exactly has been promised, and what return does the market require today for that promise? This lesson covers the first question; the rest of the track covers the second.

The terms you find in every bond's documentation:

• Face value (par, principal): the amount repaid at maturity and the base on which coupons are calculated.
• Coupon rate: the annual interest as a percentage of face value. It is fixed when the bond is issued, whatever happens to market rates later (floating-rate notes are a later lesson).
• Coupon frequency: how often the coupon is paid. Many bonds pay semi-annually, so each payment is half the annual coupon; some pay annually or quarterly. In this track, coupons are semi-annual unless a bond is described otherwise.
• Maturity date: when the face value is repaid and the bond ends.
• Issuer and ranking: who owes the money, and whether the bond is senior or subordinated, secured or unsecured. These drive credit risk, and so the yield investors demand.

Premium, par and discount. A bond's coupon is fixed, but the return the market requires moves every day. When the required yield is above the coupon rate, the bond must trade below 100 (a discount) to offer that return. When it is below the coupon rate, buyers pay more than 100 (a premium). When they are equal, the bond trades at par, 100. As maturity approaches, the price converges to 100, because that is what will be repaid.