> Introduction to Bonds

Introduction to Bonds

Posted on Tuesday, December 18, 2012 | No Comments

As most of these posts usually start, I'll begin with a definition from somewhere (wikipedia?) and try to explain it in layman's terms. I like this approach the most.

"A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity.[1] Interest is usually payable at fixed intervals (semiannual, annual, sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market."

So, firstly, let's begin with the first part of the definition. No, a bond is not an instrument like a guitar or a piccolo. It's an abstract device that's used by corporations and governments. Essentially, companies sell bonds as a way to raise money to fund for capital expenditures. If a company says "Oh, we need $200,000 more dollars to expand our operations into China.", then they might raise that money by selling bonds. This is a key concept to remember, and one that I had trouble with when I just started learning all these business terms.

Buying Bonds = Lending money to Government/Corporations
Selling Bonds = Borrowing money

Now, why would anyone want to lend corporations or the government money anyway? Is there a benefit to this? The answer is yes. The seller of the bond pays the bond back in payments, with the interest either being blended into the payments, or the payments being pure interest and the principal being paid fully at the end. So if you buy a $200,000 10 year bond with an interest rate of 10% payable annually then the interest payments are either $20,000 a year with a $200,000 lump sum payment at the end or the $200,000 gets blended in with your interest payments (this will lead to higher payments) and you get nothing at the end. There really isn't a difference though, depends on your desire for current income.

The maturity date is self-explanatory; it's when the bond matures a.k.a when it expires and the full payment + interest must be repaid. Bonds are further complicated by being issued in the secondary market, similar to stocks. To be brief, if the bond pays 10% and the market (other bonds) pay 8%, the 10% bond can sell at a premium and you can make a quick buck because the market interest rates went down. When interest rates go down, this is typically how you can profit and sell your bond if you think interest rates might rise again. If you have an 8% bond and the market (other bonds in the market) is paying 12% then you're really at a loss if you're buying bonds because other bonds are paying a higher interest than the ones you have. These are sold at a discount (lower than facevalue).

Valuing a bond is much easier than valuing a stock, since it can be done mathematically. However, this will be discussed further in a later post as I'm not exactly time-inclined to give a financial math lesson.

Good luck!

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