If you’re asking “What are bonds?” you’re probably interested in earning a certain rate on your money over time. Earning a known rate on your money can help you plan for the future, so you’re probably interested to know more about how bonds work. In short, a bond is a type of loan arranged by a government or corporation.
If the government needs to repair roads or create programs to serve its residents, issuing bonds can generate enough money to accomplish these goals. In return, the government agrees to pay bondholders, its lenders, a certain rate of return over a known period of years. Governments are sovereign entities and, unlike other types of borrowers, governments usually don’t put up collateral or security to protect their bondholders. In most cases, the country’s sovereign agreement to repay its lenders is enough. In recent years, however, countries like Greece—whose debt represents almost twice its gross national product—have increased the need to know your borrower.
Bondholders Are Lenders
If you’ve ever taken out a loan from a bank or if you have a mortgage, you’ve borrowed money. Before your lender approved the loan, your ability to repay the loan was considered. Your job, assets, and reliability were considered before the loan was approved.
Sometimes, your lender asks for collateral to ensure repayment of the loan. In the case of your mortgage, the loan is actually secured by the home. If you want money for general purposes and your banker isn’t in the business of making unsecured loans, you may receive a request to deposit collateral of some form to get approved.
When a government or corporation needs to borrow a large sum of money, they’re more likely to go to the public market to raise money. Typically, the borrower in this case plans to sell bonds that trade on an exchange in the secondary markets. Any member of the public will be able to buy or sell the issuer’s bonds. The bondholder than buys a portion of the issuer’s debt.
An investment bank helps them to file a bond issue and, once filed, may also help them to place (or sell) the bonds to customers. If the bond issue is large, the investment bank creates a syndicate or group of other banks to distribute the bonds.
Bond Issuers are Borrowers
Many bond issues are like arranging an unsecured loan. If the borrower has good credit, such as the U.S. government, lenders will agree to make the loan without asking for collateral. In that case, the bond is arranged with a kind of “IOU.” The government agrees to repay your interest and principal according to the terms of the issue and you agree. A bond is a type of fixed income security because the issuer provides the schedule and terms under which your money is returned.
In most cases, you send money to the broker-dealer or custodian to buy bonds at face value. For instance, if you purchase USD 10,000 of a new issue, you’ll probably send USD 10,000. Each bond is quoted at a percentage of 100. If the bond is priced at par, you pay 100 percent of the bond’s face value.
You then receive regular interest payments until the bond becomes due. At that time, the government returns your money:
- The interest rate is frequently called the bond coupon.
- The bond due date is called the maturity date.
Let’s take a look at an example. Let’s say you purchase a bond at face value (100). You pay USD 1,000 per bond and purchase 10 bonds. The coupon of the bond pays 8 percent. The bond matures in 10 years:
- You purchase USD 10,000 of the issue.
- You receive USD 80 per bond each year, or USD 1,000 times 8 percent, for 10 years. Your interest is paid twice per year, so you receive two pays of USD 40 each every year for the next 10 years.
- When the bond maturity date arrives, the issuer returns your original USD 10,000. At that time, you must decide how to reinvest the principal.
If interest rates are higher when your bond matures, you can decide to buy another bond with a higher coupon rate. If you’re concerned that interest rates will rise, you might decide to buy two different maturities instead of one. If you believe that rates will go down, you might decide to buy a longer maturity rate.
Bonds vs. Stocks
If you’re wondering “What are bonds?” in relation to stocks, you’ve asked an important question. Now you know that bonds are a form of debt or loan. Stocks are actually equity or ownership of a percentage of the company:
- As a bondholder, you’re the issuer’s lender. You don’t have voting rights or a say in the issuer’s operations. In contrast, stockholders are partial owners of the business. Each share of stock confers voting rights as well as the right to share in future profits of the company.
- Bondholders are creditors to a government or corporation. Your claim on assets is higher than a stockholder’s rights because debt is considered senior to equity. In a bankruptcy, creditors’ claims are paid before those of shareholders.
Bondholders don’t participate in the issuer’s profitability because, as a creditor, bondholders have the right to receive return of principal plus agreed-upon interest until the bond matures.
Although most financial experts continue to write that it’s less risky to own bonds than stocks, it’s important to evaluate the borrower’s ability to repay. If the borrower has a lower credit than the best bond loan borrowers on the market, the bondholder creditor should look for a higher interest rate coupon or additional security.