Most simply, bonds represent debt obligations – and therefore are a form of borrowing. If a company issues a bond, the money they receive in return is a loan, and must be repaid over time. Just like the mortgage on a home or a credit card payment, the repayment of the loan also entails periodic interest to be paid to the lenders. The buyers of bonds, then, are essentially lenders. For example, if you have ever bought a government savings bond, you became a lender to the federal government. Put differently, bonds are IOUs.
Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams or other infrastructure. The sudden expense of a war may also demand the need to raise funds. Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. Bonds provide a solution by allowing many individual investors to assume the role of lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals – long after the original issuing organization raised capital.
Of course, people wouldn’t lend their hard-earned money for no compensation – there is an opportunity cost involved with any investment, which is the lost opportunity of using those same funds for another purpose. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of the interest payments, which are made at a predetermined rate and schedule. The date on which the issuer must repay the amount borrowed (an amount known as the face value) is called the maturity date. The interest rate associated with a bond is often referred to as the bond’s yield or coupon. In the past, when bonds were issued as paper documents, there would be actual coupons that investors would clip and redeem for their interest payments.
Bonds are often referred to as fixed-income securities because the borrower can anticipate the exact amount of cash they will have received if a bond is held until maturity. For example, say you buy a corporate bond with a face value of $1,000, a coupon of 5% paid annually, and a maturity of 10 years. This tells you that you will receive a total of $50 ($1,000 x 0.05) of interest per year for the next 10 years (because most corporate bonds pay interest semi-annually by convention. You'd then receive two payments of $25 a year for 10 years. When the bond matures in a decade, you'd then get your $1,000 back.
In our example, the bond was issued with a fixed interest rate, but often a bond carries a variable rate. Variable interest is typically calculated as some predetermined spread above some benchmark rate, such as the Fed Funds Rate or LIBOR, and which are reevaluated after each successive coupon payment.
A key distinction alluded to in the introduction of this tutorial is that bonds represent debt while stocks represent equity. Equity represents a claim on future profits and the value of a stock can rise rapidly for a growing, profitable company. Likewise, the price of stock can drop to zero in the event of a bankruptcy. Bonds, on the other hand, only pay a pre-determined interest payment and their prices are bound by interest rates, and not by a company’s profitability. If a bankruptcy occurs, bondholders must be repaid from a liquidation in full before any shareholders are paid anything. The upshot for investors is that bonds are therefore lower risk investments, but also do not offer the potential upside that stock can offer.
Bond Basics: Characteristics
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