What Are Bonds?

What Are Bonds?

Bonds are essentially loans issued by persons comprising a public market whom collectively hold a greater capacity to loan money to large businesses and organizations than standard banks.  Just like individuals and families require loans from time to time to finance their goals, so do companies and organizations.  However as alluded to above, the amount of money required to finance large business endeavors can rarely be accommodated by the banks.  Therefore, one solution is to raise money by issuing bonds to the public market whom collectively have the monetary capacity to finance an organizations financial goals. A bond is simply a loan issued by a public lender who also fills the role of an investor that expects a pay-off for providing the loan.  Although bonds may appear to be not as lucrative as the exciting world of stocks, the financial stability they offer is bar none.

Bond Basics

It is critical to discuss and define the concepts and terms utilized when dealing with bonds. Most of these concepts pertain to the investor’s initial investment and its ability to generate monetary values. Of most importance is the amount of money a bond holder will get in return for issuing the bond or after the bond matures. This concept is referred to as the “face value”, which is also referred to as the par value or principal. It is important to keep in mind the face value is not the initial price of the bond, for a bond’s value often fluctuates. When a bond sells for more than its face value, it is said to be selling at a premium. A second concept critical to understanding bonds is referred to as the interest rate or the coupon.  The term coupon derives from the fact that interest can be collected off the bond which historically could be returned by redeeming a physical coupon as a certificate of manifest.  Typically bonds pay out interest every six months which is expressed as a percentage of the bond’s face value.  For example, if a bond pays 10% interest and its face value is $1000, then one can expect $100 in return on interest or coupon. A third concept relating to bonds is coined “maturity”. Maturity denotes a future prediction of which the bond is able to repay the investor’s principal. Lastly, the issuer of a bond is said to be a crucial factor to consider when dealing with bonds. The issuer’s stability is the main determinate for ensuring the investor’s principal will be paid back.

Important Aspects Of Bonds

As alluded to above, price fluctuation plays a large role when dealing with bonds because a bonds price changes on a day-to-day basis. Here the concept of “yield” can be incorporated into the bond’s ability to generate monetary value. Yield indicates a figure displaying the return one will receive on a bond, to calculate it simply divide the coupon amount by the price of the bond.  When a bond is bought at par the yield is equivalent to the interest rate. As such, when the price changes so does the yield.  Although the latter concepts discussed play pertinent roles in the price of a bond, the largest factor influencing a bond is the level of prevailing interest rates in the economy. When interest rates in the market rise, the bond decreases in response which correspondingly raises the yield of older bonds in the market and align them with newer bonds that are issued with higher coupons.  On the contrary, when interest rates decline, the prices of bonds in the market increase in response. This correspondingly lowers the yield of older bonds, and aligns them with newer bonds that were issued with lower coupons.

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How To Make Money Using Bonds

The two primary investments are stocks and bonds. Stocks tie a person’s investment to the percentage of their ownership or share in a corporation. Here the value of the stock fluctuates based on what the investors or the market as a whole feels what the company is worth.  Unlike stocks, a bond does not buy ownership in company but rather loans money to the company. In return for providing the loan the company will then pay interest. This practice is nearly identical to the banks loaning individuals money for cars, mortgages, or personal lines of credit. Therefore, bonds generate income in the form of interest which is tied to the principal investment. As a result bonds are typically more stable than stocks because the investor can count on interest payments which are then backed by the market’s faith in the  government’s credit to repay.

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