What is a bond? Loans, coupons and repayment

A loan with a date

A bond is born when a government, a company or an international institution borrows money and undertakes to repay it on a fixed date, paying interest in the meantime. By buying it you become its creditor: you can buy it at issue or from an investor who already holds it.

That is what the Italian word for bond, obbligazione, says: the issuer obliges itself. A bond binds the issuer. The document that fixes amounts, dates and terms is the bond’s contract. Everything you are owed is written there: how much you receive, when, and what happens in special cases.

Whoever holds a bond is a creditor. They do not become a shareholder, as a rule do not share in profits and do not vote at the general meeting. This is the main difference from a share: the shareholder owns a part of the company and follows its fortunes, the bondholder has a claim to collect. The definitions published by Consob and Banca d’Italia start from the same point.

Three questions open the reading of any bond: who am I lending to, which payments am I owed, when. The rest of this guide is about answering those three questions well.

Alfa: our worked example

To avoid reasoning in a vacuum we will use an invented bond, Alfa. It has a face value of €1,000, pays a fixed coupon of 3% a year, lasts five years and repays the €1,000 at the end. It has no special clauses: for instance, it cannot be repaid before maturity (chapter 3). It does not exist on the market: it is there to do the sums without having to know everything from the start.

Buying Alfa at €1,000 you receive €30 every year for five years and, together with the last coupon, the €1,000 of principal. The coupons add up to €150. The final €1,000 is not a gain: it is your loan coming back.

This is the path of the money if everything goes as written. The “if” is not a courtesy: every payment depends on the issuer’s ability to make it. We come to that in chapter 4.

Five key terms

Five words come back in every factsheet, order and document, and they answer the three questions: the issuer says to whom; coupon and face value say how much; maturity says when. The price is what you pay.

Bond prices are quoted “per 100 of face value”: 98 means €980 for €1,000 of face value, 102 means €1,020. You will find it written that way in the Rebalix calculator too.

A real bond follows the same pattern. The BTP (Buono del Tesoro Poliennale), the Italian medium- to long-term fixed-rate government bond, pays a fixed coupon every six months and repays the face value at maturity, as the Italian Treasury describes. The numbers and the frequency change, not the logic.

Why the price changes every day

In the primary market the bond is born: the issuer sells it for the first time and receives the money. In the secondary market it changes hands between investors: the buyer pays the seller, and the issuer receives nothing new. A retail investor can buy in both: at issue, through the bank, or on the secondary market, where the bond already has a price that moves.

It is the secondary market that produces the price you see change every day. Alfa’s contract stays the same (€30 a year and €1,000 at the end), but the price investors are willing to pay for it moves. Among the main reasons are market interest rates (chapter 8) and the judgement on who has to pay (chapter 4); others, such as liquidity, come in chapter 9.

Imagine three possible purchase prices for Alfa today: €1,000, €980 or €1,020. The future payments do not change: €150 of coupons and €1,000 of repayment. At €1,000 the overall result is the €150 of coupons. At €980 you paid €20 less for the same cash flows: €150 of coupons plus €20 of difference between the €1,000 repaid and the €980 paid, i.e. €170. At €1,020 the difference works against you: 150 − 20 = 130.

This gives a rule that holds for the whole guide. Same date, same future payments: whoever pays less earns more. How to turn that difference into an annual yield is the subject of chapter 6; why the price moves when rates change, of chapter 8.

A promise is not a guarantee

A bond describes what must happen. It does not ensure that it happens. If the issuer runs into difficulty it may pay late, pay less or not pay: the contract then becomes a claim to be enforced, with uncertain timing and recovery.

This is why “bond” is not a synonym for guaranteed capital, nor for a fixed coupon (there are floating-rate and zero-coupon bonds: chapter 5), nor for the absence of losses. Not even for bonds issued by a bank: deposit guarantee schemes protect eligible deposits, within the limits and conditions of the scheme that applies to that bank, not the bonds the bank has issued. Buying a bank bond means taking on the bank’s credit risk: in a crisis bondholders are creditors and can be called on to absorb losses after the shareholders, as Banca d’Italia explains for the Italian case.

There is one practical consequence: before looking at how much it yields, ask who pays. The type of issuer (government, company or international institution) is the first clue and we look at it in chapter 2; the judgement on its soundness comes in chapter 4.

Assumptions of this chapter. All amounts are gross: no commissions, taxes or accrued interest (the interest built up between one coupon and the next: chapter 6). The payments are those written in the contract and arrive only if the issuer pays. Alfa is a teaching example, not an existing bond.

Where you see it on Rebalix

Three of the five words of this chapter are columns of the Rebalix bond search: issuer, coupon and maturity, alongside ISIN, currency and exchange of the government, supranational and corporate bonds (chapter 2) recorded in the public European registers (chapter 3). The price is not there: Rebalix describes the contract, not the market of the day.

In the calculator you can rebuild Alfa by hand: price 100, quantity (“Nominal”) 1,000, annual coupon 3, one coupon a year (“Annual”), maturity five years from today, same day. The schedule shows five €30 coupons and the €1,000 repayment. The calculator also counts the interest already accrued at the settlement date: that is why the outlay can differ slightly from the €1,000 of the simplified example. You will also see taxes, inflation and a yield: those are chapters 6, 7 and 9. The words met here, and those of the coming chapters, are collected in the bond glossary.