Bonds
Introduction
Bonds are debt securities, similar to IOUs. When you purchase a bond, you are lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value when it matures. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.
Types of Bonds
There are several types of bonds, including corporate bonds, government bonds, and municipal bonds.
Corporate Bonds
Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.
Government Bonds
Government bonds, also known as sovereign bonds, are issued by national governments. Government bonds issued by major economies (U.S., Germany, Japan) are considered risk-free. As well, they are used as a benchmark to price all other bonds.
Municipal Bonds
Municipal bonds are issued by states, cities, and other local entities. They use the funds to finance public projects such as schools, highways, and bridges.
Bond Features
Bonds come with a variety of features that investors need to understand.
Face Value/Par Value
The face value, or par value, of a bond is the amount of money that the holder of the bond will receive from the issuer of the bond when the bond matures.
Coupon Rate
The coupon rate of a bond is the rate of interest that the bond issuer will pay to the bond holder annually.
Maturity Date
The maturity date of a bond is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
Issue Price
The issue price of a bond is the price at which the bond is originally sold to investors.
Bond Pricing
The price of a bond is determined by the market and is often different from its face value. The price can be affected by various factors, including interest rates, supply and demand, credit quality, and duration.
Bond Yields
The yield of a bond is the return an investor realizes on a bond. The yield is usually expressed as an annual percentage, based on the investment's cost, current market value, or face value.
Bonds vs. Stocks
Bonds and stocks are both securities, but the major difference between the two is that stockholders have an equity stake in a company (i.e., they are owners), whereas bondholders are in a creditor relationship with the company (i.e., they are lenders).
Bond Risks
While bonds are often considered 'safer' than stocks, they are not without risk. The main risks associated with bonds include interest rate risk, issuer default risk, and liquidity risk.
Conclusion
Bonds play a critical role in the financial markets and can be a valuable investment tool for both individuals and institutions. Understanding the basics of bonds can help investors make informed decisions and potentially enhance their investment returns.