Bonds are issued by entities such as government agencies, corporations, and financial institutions. They represent a debt security where the issuer commits to making periodic interest payments as agreed upon in advance and, upon maturity, repays the bond’s face value to the holder.

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Principal and Coupon

For bond investors, purchasing a bond is akin to lending money to the issuing entity, which periodically pays interest (the coupon) as compensation. Upon the bond’s maturity, the issuer will also return the initial investment, known as the “principal.”

The principal is also referred to as the bond’s face value or par value. The coupon is paid at specified intervals (such as semi-annually or annually) and is expressed as a percentage of the principal. While the coupon is typically fixed, some bonds are indexed to certain metrics, meaning their coupon rates may be adjusted by changes in the index (such as inflation rates).

Trading Bonds

Bonds are typically transferable securities, allowing them to be bought and sold on the secondary market like stocks. However, unlike stocks, while some bonds are listed on exchanges such as the London Stock Exchange (LSE), the majority of bond trading occurs over-the-counter (OTC) through institutional brokers.

Similar to stocks, bond prices are influenced by market supply and demand, enabling investors to profit by selling bonds when prices rise or vice versa. Compared to stocks, bonds, as a debt instrument, are more affected by interest rate fluctuations.

When interest rates rise, bonds become less attractive relative to other investment products that offer higher yields, leading to a decrease in prices; conversely, when interest rates fall, the appeal of bonds increases, causing prices to rise.

Types of Bonds

Classified by Issuer Identity

Typically, when we hear about different types of bonds, they’re often categorized based on the entity issuing them. When an organization needs to raise funds, it might find more favorable interest rates in the bond market than other lending sources like banks. These bonds can be primarily divided into four main categories:

Government Bonds

Issued by national governments, government bonds generally offer the best liquidity and the lowest credit risk. In the United States, these bonds are known as Treasury Inflation-Protected Securities (TIPS), while in the United Kingdom, they are referred to as index-linked gilts. Although all investments carry risks, sovereign bonds from mature and stable economies are classified as low-risk investments, with their repayment capacity backed by the government’s creditworthiness.

International Agency Bonds

Bonds issued by multinational international institutions, such as the World Bank, International Monetary Fund (IMF), Asian Development Bank, and European Investment Bank, typically carry international credibility. They generally have lower risk than corporate bonds and exhibit stability similar to government bonds.

Corporate Bonds

Corporate bonds are issued by companies to raise investment funds and generally carry higher risk compared to government bonds, but they also offer greater potential returns. The credit ratings of corporate bonds can vary, resulting in different risk levels. Bonds issued by financially stable companies tend to be more secure, while those from financially weaker companies (often referred to as junk bonds) carry higher risks. Ratings agencies such as Standard & Poor’s, Moody’s, and Fitch Ratings evaluate the bond grades, and investors need to be aware of the issuer’s ability to consistently and timely repay interest and principal. Issuers can use these ratings to set bond prices to attract investors.

Additionally, when investors purchase corporate bonds, they become creditors, enjoying more loss protection than shareholders. In the unfortunate event of a company’s liquidation, bondholders are prioritized for compensation over shareholders.

Municipal Bonds

Municipal bonds are issued by local governments or municipal agencies to finance infrastructure projects (such as bridge construction, school building, and general operations). They often offer tax-exempt income. Other developed countries also issue provincial or local government bonds.

Classified by Coupon Payment Method

Fixed Rate Bonds

These bonds have a fixed coupon rate that remains unchanged throughout the bond’s life, allowing investors to receive interest income consistently. Their returns are relatively stable, but the fixed coupon may become less attractive when interest rates rise compared to floating rate bonds.

Floating Rate Bonds

The coupon rate of these bonds adjusts with fluctuations in market interest rates, often referencing a benchmark rate (such as the U.S. Federal Funds Rate). This type of bond can provide higher interest payments when rates rise, making it better equipped to withstand interest rate volatility.

Zero-Coupon Bonds

Zero-coupon bonds do not pay periodic interest; instead, they are issued at a discount. Investors receive the face value at maturity, and their profit is the difference between the purchase price and the face value.

U.S. Treasury Bonds

The most well-known bonds are undoubtedly U.S. Treasury Securities (UST), issued by the U.S. Department of the Treasury through the Bureau of the Fiscal Service. The government issues these bonds to raise funds from investors to promote economic development, allowing bond investors to earn interest and receive their principal back at maturity.

U.S. Treasury securities can be classified into transferable and non-transferable bonds. The former is further divided based on maturity into Treasury Bills (short-term), Treasury Notes (T-Notes), Treasury Bonds (T-Bonds), and Treasury Inflation-Protected Securities (TIPS). In addition to varying maturity periods, these securities differ in their issuance frequency.

Classification of U.S. Treasury Securities

U.S. Treasury Bills (T-bills) are bonds with maturities of one year or less; Treasury Notes (T-notes) have maturities ranging from two to ten years; and Treasury Bonds (T-bonds) can have maturities of up to 30 years.

Classification of U.S. Treasury Securities

Note: The 10-year U.S. Treasury bond is considered to be between medium and long-term. Many market participants use it to assess overall monetary policy or as an economic indicator.

U.S. Treasury Yield

U.S. Treasury Yield = (Bond Coupon Interest / Face Value) × 100%

The U.S. Treasury yield represents the total interest investors can earn from investing in U.S. government bonds. While the bond’s coupon interest remains constant, the face value fluctuates with the market. When the face value rises, the yield decreases.

Factors Influencing Bond Prices

The price of a bond and its yield determine its value in the secondary market. Bonds must have a market price for trading, and the yield represents the actual return that investors will earn if they hold the bond until maturity.

Supply and Demand of Bonds

Like most traded assets, bond prices are influenced by supply and demand. When supply exceeds demand, bond prices will fall, and vice versa.

Bond Supply

The supply of bonds primarily depends on the funding needs of the issuing entities:

• Government Issuance of Treasury Bonds: When the government needs funds for infrastructure projects or to cover budget deficits, it will increase the issuance of bonds.
• Corporate Issuance of Corporate Bonds: Companies will issue corporate bonds when they need funds to expand their business, engage in mergers and acquisitions, or refinance existing debts.

Demand for Bonds

Demand for bonds depends on their attractiveness as an investment tool, which is related to the opportunity cost compared to other investment options (like stocks or real estate). Demand is influenced by the following factors:

• Economic uncertainty: During economic downturns or market volatility, investors typically seek more stable investment tools, such as government bonds. At this time, demand for low-risk bonds increases, leading to higher prices.
  • For instance, during the 2008 global financial crisis, demand for U.S. Treasury bonds surged.
• Interest rate changes: When market interest rates decline, existing bonds with fixed coupon rates become more attractive, increasing demand and driving up bond prices; conversely, when interest rates rise, demand may decrease.

Maturity period

The pricing of newly issued bonds takes into account current interest rates. Newly issued bonds typically trade at prices close to their face value. As the bond’s maturity date approaches, its price gradually aligns with its face value, since the issuer only needs to repay the original principal at maturity.

Additionally, the number of remaining interest payments before maturity also affects its price. If there are still many interest payments left before maturity, the bond’s attractiveness will be higher, and its price may be slightly above face value; conversely, the opposite is true.

Credit Rating

Although bonds are considered conservative investment tools, they still carry default risk.

Higher-risk bonds typically trade at lower prices compared to lower-risk bonds with similar interest rates because investors demand higher returns to compensate for the risk taken on.

Credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch assess the creditworthiness of bond issuers, assigning ratings based on their financial condition and repayment ability. High ratings (e.g., AAA) indicate a very low risk of default, while low ratings (e.g., BB or below) signify higher risk; these bonds are often referred to as high-yield or junk bonds.

Inflation

The adverse effects of high inflation rates on bondholders can be attributed to several factors:

Inflation erodes the purchasing power of fixed coupon payments.

The coupon payments of bonds are typically fixed, meaning investors receive the same amount of interest each year, regardless of market conditions. However, when inflation rises, the purchasing power of money decreases, reducing the real value of fixed coupon payments.

Rising interest rates lead to a decline in bond prices.

To combat high inflation rates, central banks typically raise benchmark interest rates in an attempt to cool down an overheating economy. When market interest rates rise, newly issued bonds offer higher coupons, making existing low-coupon bonds less competitive in the market. Additionally, long-term bonds are more susceptible to price fluctuations than short-term bonds when interest rates increase.

The protective function of inflation-indexed bonds.

Although most bonds perform poorly during high inflation, certain bonds, such as inflation-indexed bonds (like the U.S. Treasury Inflation-Protected Securities, or TIPS), offer inflation protection. The principal of TIPS adjusts with the inflation rate.

For example, suppose an investor holds a TIPS bond with a principal of $10,000. When the inflation rate is 3%, the principal of the TIPS will adjust to $10,300, and future interest payments will be based on this higher principal. This allows the investor to maintain the real purchasing power of their returns.

Advantages of Investing in Bonds.

Capital Protection

Unlike stocks, bonds require issuers to repay the principal to bond investors by a specified date or upon maturity. This feature attracts investors who are averse to capital loss, as well as those needing to fulfill future obligations at a particular time.

Regular Interest Distributions

During the holding period, bond investors receive periodic interest payments (typically quarterly, semi-annually, or annually) based on the coupon rate specified in the bond’s issuance terms. This makes bonds particularly suitable for conservative investors or those requiring stable cash flows, such as retirees or income-focused investors.

Potential Capital Gains

Certain government bonds and bonds issued by large corporations enjoy higher liquidity in the secondary market. Investors needing liquidity can readily buy and sell these bonds, quickly converting assets into cash. Additionally, investors can benefit from capital gains if the bond’s selling price exceeds its purchase price.

Lower Volatility Compared to Stocks

Bond prices tend to fluctuate less than stock prices, making bonds a relatively low-risk option.

Additionally, as debt instruments, bondholders have a higher claim priority over shareholders in cases of issuer bankruptcy or liquidation.

Government bonds and high-credit corporate bonds generally carry lower risk, as issuers are usually better positioned to fulfill repayment obligations, allowing investors to reclaim principal upon maturity. Bonds are a crucial choice for capital preservation, especially during economic uncertainty.

Hedging

Including bonds in an investment portfolio helps diversify asset classes such as stocks, bonds, and commodities, aiming to mitigate the risk of low returns or heavy exposure to a single asset type.

Bonds can protect investors during economic downturns, as most bonds offer stable coupon payments unaffected by market fluctuations. This stability makes bonds particularly attractive when the economy slows. Furthermore, during deflation, bond yields can be used to purchase goods and services, adding to their appeal. As bond demand rises, bond prices may increase, enhancing investor returns.

Risks of Bond Investment

Credit Risk (Default Risk)

Credit risk is the possibility that the bond issuer may fail to pay interest or principal in full and on time. In extreme cases, the debtor may completely default. Rating agencies assess issuers’ creditworthiness and assign ratings based on these evaluations.

Interest Rate Risk

Interest rate risk is the risk that rising interest rates will lead to a decrease in bond prices. Higher rates can affect the opportunity cost of holding bonds when other assets offer better returns.

Generally, when interest rates fall, fixed-rate bond prices rise; conversely, when rates rise, fixed-rate bond prices tend to drop. If an investor plans to sell a bond before maturity, the sale price might be lower than the purchase price.

Furthermore, long-term zero-coupon bonds are more sensitive to interest rate changes than short-term ones, as zero-coupon bonds repay principal only at maturity without periodic interest payments. Their value is calculated by discounting the principal repayment at maturity, making shorter-term bonds less impacted by interest rate fluctuations.

Inflation Risk

Rising inflation can decrease bond prices, as inflation rates that exceed a bond’s coupon rate reduce purchasing power and lead to real losses on returns. However, inflation-linked bonds can help mitigate this risk.

Currency Risk

For bonds denominated in foreign currencies, holders face the risk of exchange rate fluctuations. If a foreign currency depreciates when converting the principal and interest to the local currency, the investor’s returns will be reduced.

Tokenized Government Bonds

Tokenized government bonds convert U.S. Treasuries (or other government bonds) into digital assets. Using blockchain or similar technology, the ownership of physical bonds is represented in token form, enabling transparent bond trading and greater transaction efficiency and flexibility.

Advantages of Tokenized Government Bonds

24/7 Instant Settlement

Tokenized government bonds use blockchain technology for real-time settlement, removing the settlement time limitations of traditional bond markets and improving investors’ capital flexibility.

Increased Liquidity

Tokenized U.S. Treasuries boost liquidity further, allowing investors to easily trade bonds in smaller units, consolidate, or settle instantly, increasing both transaction fluidity and convenience.

Enhanced Investment Transparency

Blockchain technology records transactions on a public, decentralized ledger, reducing the risk of improper trading and increasing transparency and fairness in government bond transactions.

Lower Transaction and Custody Fees

The transaction and custody fees for tokenized bonds vary by platform (exchange or issuer) but generally require minimal gas fees, lowering investment costs.

Overview of Tokenized Government Bond Projects

Franklin OnChain U.S. Government Money Fund

Franklin Templeton, a well-known asset management company, launched the Franklin OnChain U.S. Government Money Fund, one of the first tokenized money market funds based on blockchain, operating on the Stellar and Polygon networks. Franklin has invested over $300 million in tokenized government bonds, positioning itself as a key leader in this market.

BUIDL, BlackRock USD Institution Digital Liquidity Fund

BlackRock, the world’s largest asset management firm, also launched a tokenized fund, BUIDL, on Ethereum. Using Coinbase as its primary infrastructure provider, the fund exemplifies the synergy between traditional finance and blockchain. With a minimum investment threshold of $5 million, BUIDL attracts capital-rich institutions and individuals seeking stable, secure entry points into digital assets.

Ondo Finance

Founded in 2021, Ondo Finance initially focused on decentralized exchanges. In early 2023, it launched its first tokenized fund, encompassing various ETFs like U.S. government bond funds and U.S. government money market funds, offering investors token-based ETF investment opportunities.

OpenEden

OpenEden, a blockchain technology company founded by former Gemini team members, is the first on-chain tokenized U.S. Treasury investment platform. Backed 1:1 by U.S. Treasuries and USD, OpenEden’s T-Bills Vault allows investors to invest in and redeem Treasuries 24/7, offering high transparency and liquidity.

Conclusion

In summary, bonds are an investment tool that provides coupon income and relatively low risk, making them particularly suitable for investors seeking stable returns. However, bond prices are influenced by factors such as interest rates, inflation, and credit risk. During economic downturns, the attractiveness of bonds increases, offering investors stable income and protection. Additionally, different types of bonds, such as government bonds, corporate bonds, and floating rate bonds, cater to various investment needs. Therefore, investment choices should be based on individual risk tolerance and market conditions.