Updated Jan 29, 2022

What is a Bond?

What is a bond?

An investor lends money to a borrower in the form of a fixed-income instrument known as a "bond" (typically corporate or governmental). It is common for businesses and governments to use bonds to raise money for projects and operations. Bondholders are those who owe money to the issuer. If you have a fixed-rate or variable-interest bond, you can specify how much you owe in principal and how often you pay it back to the owner. Here’s a guide for you to understand the concept better.

Various Types of Bonds

Corporate bonds: Companies are the ones who issue these bonds. The bond market's lower interest rates and advantageous terms make it more common for companies to issue bonds rather than seek bank loans for debt financing.

Municipal bonds: States and municipalities can issue their bonds, known as municipal bonds. Some municipal bonds allow investors to receive tax-free coupon income.

Government bonds: Treasury bonds with maturities of one year or less are called "Bills," those with maturities of one to 10 years are called "notes," and those with maturities of more than ten years are called "bonds." The entire group of government bonds issued by the Treasury is called "treasuries". Government bonds issued by governments of sovereign states are called sovereign debt.

What is the process of buying and selling bonds?

Governments and enterprises sell bonds to raise capital by issuing them the security to the public. Selling bonds is, thus, borrowing money for the seller. According to the buyer's standpoint, bonds are an investment because the purchaser is guaranteed to receive their money back in addition to receiving interest payments. Other advantages of some bonds include the possibility of converting the bond into stock in the issuing corporation. The price of bonds will go down when interest rates go up. When interest rates go down, bonds will sell comparatively more.

Benefits of investing in bonds

1. Bonds provide income

Bonds tend to have the greatest and most consistent cash flows of any investment. Investing in a portfolio that provides you with a steady income stream is possible even when interest rates are at historic lows. High-yield bonds and emerging market debt are examples of these strategies.

2. Bonds Provide a Wide Range of Investment Options

This Reduces the return-on-investment relative to the risk. More crucially, bonds can help equity investors protect capital when the stock market is tumbling.

3. Bonds Protect Principal

As people get closer to needing the money they've saved, fixed-income investments might be a great asset. For example, a person about to retire or a parent whose child is starting college could benefit from such investments.

4. Tax advantages

Tax-saving opportunities exist in some types of bonds as well. As long as these investments are held in a tax-deferred account, they are subject to income tax. It is also tax-free as long as you possess a municipal bond issued by the state where you live. On the state and local level, the income from U.S. Treasury securities is tax-free.

Characteristics of bond

• Interest payments are calculated based on "face value," or the amount a bond is expected to be worth when it matures. The coupon rate is the bond's face value percentage that the issuer will pay in interest.

• The dates on which the bond issuer will make interest payments are coupon dates. Semi-annual payments are the norm, but they can be made at any time.

• Bonds mature at a certain point in time, and the bondholder will receive their full face value than from the bond issuer.

• The price at which the bond issuer initially offers the bonds is known as the "issue price."

Example of a bond

Use ABC Corporation as an example. ABC can't acquire a bank loan for $1 million to fund the development of a new plant. Instead, ABC decides to issue $1 million in bonds to investors to raise the necessary funds. ABC has agreed to pay its bondholders an annual interest rate of 5% for the next five years, with interest due every two months. ABC is offering a total of 1,000 bonds with a face value of $1,000 each.

Conclusion

When an issuer issues a debt instrument, it is known as a "bond." When a company issues a bond, it promises to make interest and coupon payments to the person holding the bond and repay the principal at maturity. While both bonds and stocks are considered financial securities, stockholders own a piece of the corporation outright, whereas bondholders are merely creditors. One of the main differences between bonds and stocks is that bonds often have a predetermined period, or maturity, during which the bond is repaid. However, a perpetual or irredeemable bond is an exception.