“How Bonds Work”
Professor Gary Barth
August 11, 2013
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer. In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due. Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage, and asset-backed securities, federal agency securities and foreign government bonds. Bonds can be also called bills, notes, debt securities, or debt obligations.
Without loans, most of us wouldn't be able to afford things like a car, a home or education. And, just as people borrow money to help them succeed, so do businesses. Businesses often need loans to fund operations, move into new markets, innovate and grow in general. But the amount they need often surpasses what a bank can provide. So another useful way for corporations to raise the necessary funds is to issue bonds to whoever wants to buy them. A bond works the same way a regular loan does. When you buy a bond, you're lending money to the organization that issues it. The company, in return, promises to pay interest payments to you for the length of the loan. How much and how often you get paid interest depends on the terms of the bond. The interest rate, also called the coupon, is typically higher with long-term bonds. These interest payments are usually doled out semiannually, but they can also be sent out annually, quarterly or even monthly. When the bond reaches the date of maturity, the issuer repays the principle, or original amount of the loan.
Bonds can play a useful role in almost any investor's portfolio, but many people find them a little confusing. In essence, a bond represents a loan that you make to a corporation or public agency. Investors earn income through the interest bonds are paid by their issuers—the borrowers—but there are several other factors that determine how well a bond performs on the open market. Given their historical track record, bonds have a reputation as relatively stable and conservative investments. For most investors, bond funds may prove to be more practical than individual bonds. Bond funds invest in corporate, municipal, or U.S. government debt. Most have a focus on income, rather than investment growth.
If you have ever spoken with a financial advisor or read a general investing article, you know that most advisors believe you should put part of your money into bonds. Financial advisors love bonds because they are conservative, reliable investments that provide stability to any portfolio. But how exactly do they do that? When you buy a bond, you are lending money to the government or company that issued the bond, and in return, the government or company that issued the bond is agreeing to pay your money back, with interest, at some point in the future. For example, when you buy a house, a bank creates a contract, a mortgage in this case, where as the bank lends you money and you agree to pay the bank back, with interest, at some point in the future. Well, with a bond, you are like the bank, the government or company is like the home buyer and the bond is like the mortgage contract.
When most people envision a bond, they picture a certificate that states how much the bond is worth, the interest rate that will be paid out on the bond and the date on which the bond will mature, and that is correct.
Characteristics of a bond: * Face value is the amount the bond will be worth at maturity and the amount the bond issuer uses when calculating interest payments. * Coupon rate is the interest rate the bond issuer will pay on the face value of the bond. * Coupon dates…