Bonds are debt instruments that are sold by a borrower to a lender in exchange for capital. Similar to loans, bonds carry a fixed rate of interest (coupon) that the borrower (bond issuer) pays to the lender (bond investor) until the maturity date, on which the borrower returns the capital to the lender.
Bonds are typically issued or sold by governments and corporations in order to raise capital for funding promising projects. They are bought by investors that are looking to earn a fixed return on their investment, paid at fixed intervals. The predictable nature of return on and return of capital is the reason why bonds are also known as fixed income instruments.
The interest or coupon on a bond is inversely proportional to the creditworthiness (ability to pay coupons and principal) of the bond issuer, all else remaining constant. Lower the issuer’s creditworthiness, higher will be the coupon on its bonds. The higher coupon is to compensate investors for taking on greater risk by lending money to an issuer with poor credit quality. To understand this better, let’s compare two bonds that have a similar maturity date.
The Singtel bond has a credit rating of A and a coupon of 2.375%, while the Theta Capital bond has a credit rating of B- and a coupon of 6.75%. The difference in coupon is largely due to the difference in creditworthiness of the two companies, as measured by the credit ratings of the two bonds.