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22 Apr    Finance

Definition of a Bond

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. A bond has an end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments that will be made by the borrower. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debt holders, or creditors, of the issuer.

Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.

How to go About Bonds

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

Bond Issuers

There are three main categories of bonds.

  • Corporate bonds are issued by financial companies.
  • Municipal bonds . Some municipal bonds offer tax-free coupon income for investors.
  • Government bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1 – 10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury are often collectively referred to as “treasuries.”

Bonds Overview

A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Bonds are issued by governments, municipalities, and corporations. The interest rate (coupon rate), principal amount and maturities will vary from one bond to the next in order to meet the goals of the bond issuer (borrower) and the bond buyer (lender). Most bonds issued by companies include options that can increase or decrease their value and can make comparisons difficult for non-professionals. Bonds can be bought or sold before they mature, and many are publicly listed and can be traded with a broker.

Bonds that make a coupon payment are called “coupon bonds”. There are also other types of bonds issued by borrowers. The convertible bond may the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

While governments issue many bonds, corporate bonds can be purchased from brokerages. If you’re interested in this investment, you’ll need Funny SA financial service firm.