What are bonds?
A bond is a debt investment in which an investor loans money to an entity. It is a fund borrowed for a certain period of time at a fixed interest rate. When an investor purchases a bond, he or she lends money to the issuer. The most common types of bonds are corporate and governmental/municipal bonds.
Bonds are commonly traded on major exchanges, but some are only available on over-the-counter (OTC) markets. Both bonds and stocks are securities; however, their major difference is that stockholders have equity in the company, while bondholders have a creditor stake in the company. Because of this, bondholders are usually prioritized over stockholders. They are paid first before the company pays dividends to stockholders.
Most bonds have a defined maturity date except for irredeemable bonds, which is a type of bond with no maturity. This bond is also called perpetual bond, “consol”, or a “perp”. Its only drawback is that it is not redeemable, but it pays a steady stream of interest payments forever.
Creditor – also called the debt holder or lender of the bond. Creditors are made up of investors who purchased bonds, which in turn are borrowed by entities.
Issuer – also called the borrower or debtor of the bonds. This issuer could be a corporation, government, or other entity. The issuer is obliged to pay back the bond principal plus the interest to the creditor at the maturity date.
Maturity date – it is the date on which the bond will expire and the bond issuer is required to pay the face value of the bond loaned. The maturity date or the time until the loaned funds is to be paid usually ranges from a day to more or less 30 days.
Face value – also called “principal”. It is the price of the bond upon its maturity. It is the original price of the bond plus the interest accumulated over time.
Issue price – it is the original price of the bond at which the issuer originally sold the bond. The issue price of a bond is usually $100 or $1,000 per individual bond. Its actual market price depends on a number of factors including the credit quality of the issuer, the time until expiration, and the coupon rate compared to the general interest rate commonly issued at the time.
Coupon rate – is the interest rate of the bonds. The coupon is usually paid at annual or semi-annual intervals. The date of which the coupon is to be paid is called “coupon date”. The interest rate of a bond is computed by looking at the credit quality of the issuer and the length of time before the maturity date.
How do bonds work?
Companies or entities issue bonds from investors instead of banks when they need to raise money for new projects, fund ongoing operations, or to pay other existing debts. These entities issues bonds at a certain price, which are then bought by investors through an exchange or on OTC markets.
The price of the bond paid by the investor would be used by the entity for its financial needs. The indebted entity or the issuer of bonds promises to pay a fixed interest rate or coupon at the time maturity date of the loaned funds.
When the maturity date comes, the issuer is obliged to pay the face value or the original price of the bond plus the coupon accumulated over time.
Importance of bonds
A bond is a fixed-income security. It pays a fixed interest a few times a year, thus providing a steady supply of profits. It is recommended for all investors to include a few bonds on their diversified portfolio to secure income from investments especially if is for retirement or savings funds.
Read more about portfolio diversification.
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