What are Bonds and How do they Work?
Along with stocks and cash equivalents, bonds are one of the three main asset classes. Financial consultants often recommend investing in bonds because they are reliable investments where you can get high amounts of returns simply by loaning out your money. As such, they provide stability, as well as diversity to any investment portfolio.
However, the average investor may not know what bonds are and how they work. In this article, we discuss what bonds are, their characteristics, how they work, and why investors buy and sell bonds.
A simple definition of bonds
In simple words, a bond is a loan made to any organization, whether it is a company or a government. A bond is borrowed by the organization for a fixed period of time at a fixed or variable interest rate.
When organizations such as corporations or governments need money for paying off debts, finance new projects or even ongoing ones, they often issue bonds to investors directly rather than approaching a bank and taking out a loan. The party that is in debt, which is the company or government that borrows the money is known as the issuer, while the one loaning the money (investors) is the bondholder.
To put it simply, buying a bond means that you are loaning your money to a corporate or a government. In return, the corporate or government agrees to pay you the loaned amount back, along with interest, after a fixed amount of time.
The issuer issues a contract which states that the interest rate, also known as coupon rate or payment will be paid, as well as the time at which the loaned amount, known as the bond principal, must be paid back to the lender. This is known as maturity date.
Characteristics of bonds
Below are the common characteristics of bonds which every investor must know:
- Bond principal, which is the total amount of money loaned by the investor to the issuer.
- Face value, which is the total sum the money will amount to at its maturity.
- Coupon rate, expressed in percentage, is the interest rate the issuer has to pay the lender on the bond’s face value.
- Coupon dates, which are the dates on which interest payments have to be made by the issuer. Usually, interest payments are made semi-annually or annually.
- Maturity date, which is the date on which the issuer must pay the lender or holder the face value of the bond.
- Issue price, which is the original price at which the bonds are sold by the issuer.
How do bonds work?
Once you understand what bonds are, it’s not very difficult to understand how they work. When bonds are issued by a corporate or a government and an investor loans the money, thereby becoming a bondholder, the corporate or government has to keep paying the bondholder interest payments at regular intervals till the face value is paid.
Many people have the assumption that buying a bond from an issuer means you cannot sell it again and must hold on till its maturity date. However, this is not true as investors can buy and sell bonds in the market, just like stocks. In fact, the bond market is huger than the stock market.
This means that bondholders resell bonds before they mature, wither on the secondary market or privately between a creditor and a broker. When a bond is sold at a market price higher than its face value, it is known as “selling at a premium.” When a bond is sold at a market price lower than its face value, it is known as “selling at a discount.” As such, the value of a bond can rise and fall until it reaches its maturity date.