January 13, 2022 4:22 PM

What is a Bond?

What is a Bond?

DEFINITION:

A bond is a fixed income instrument issued by a company, bank, or government in exchange for cash. It represents a loan made by an investor to a borrower, and it’s tradable in financial markets, similar to a stock.

Understanding bonds

In case a company needs money, there are several options to raise capital. Either to sell stock or just to borrow money for a certain period of time. A bond entity is a debt security. And lenders are the bond investors who repay their funds by those who issued the bond. The lenders could sell a bond to any other investors, allowing the bond to trade in the market. In its turn, the bond issuers have to pay back in due time or when it “matures” and often have to pay a specific interest rate, a so-called “coupon.” However, there’s no guarantee that the bondholder would get his money back.

Recap
A bond creates a borrower/lender relationship where the borrower is issuing a bind, and the lender is the investor who purchases a bond. Borrowers raise capital and get cash, while lenders usually get their interests. Nevertheless, a company, government, or other institution issuing a bond could go bankrupt, and in that case, bond investor might not get the repayment.

The critical bond terms to remember:
To understand bonds, it’s helpful to have a look at the most widely used terms around the concept.

-Principal & Interest:
These two terms are crucial when it comes to the concept of the bond. The principal is the amount of money borrowed by the party that has issued the bond. And the interest is either fixed, or flexible amount that has to be payed by the borrower, the one who has issued the bond, to the owner of the bond – the lender. Usually, it’s indicated in the percentage of the principal and typically to be paid every six months. So, in a way, interest is a price for borrowing and a benefit of lending.

-Coupon:
It is also a way to describe interest payments – it’s the annual interest rate that indicates how much a bond issuer must pay the bondholder, typically every six months, throughout the bond’s lifetime.

-Maturity date:
Maturity date is simply the end date of the bond and the time when the bond-issuing company must repay the amount to the bondholder.

Who issues bonds?
There are three different main groups of bond issuers:

1. Corporations:
One of the main reasons why companies tend to issue bonds is the circumstance in which they need to raise capital for different purposes.

2. Governments:
Federal (or also local governments in the US) also issue bonds. A bond issued by governments is the least-risky one, and in particular, in the States, they are known as Treasury bond or Treasuries. It’s widely used to raise money and capital for governmental workers’ salaries, military contracts, and many other government spendings.

3. Other institutions:
Any other organization could also issue bonds to attract capital and money for themselves for growth opportunities, expansions to new countries, or even for building new offices.

What are the bond risks?

The same as with stocks, there couldn’t be any guarantees that an investor would be able to gain profits from a bond investment. Bonds are considered less risky due to their legally binding nature with a duty to repay a bondholder. Bonds could be an excellent tool for diversifying one’s investment portfolio and balancing the overall investments. It’s important to note that bond issuers might go bankrupt, and in that situation, a bondholder might lose the entire sum or investment. Generally speaking, bonds are considered to be less volatile than stocks.

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