By Eric Brady

Money 101: What is a bond?

A bond is a way for companies (or governments) to borrow money from individual investors instead of banks.  The purchaser of the bond pays the company a small amount per bond, often $1000.  In return for the cash up front, the firm makes regular interest payments to the bondholder over the life of the bond.  At the predetermined rate of maturity, the borrow pays out the amount borrowed, or par value, to the holder of the bond.

Wrong Bonds, but if you can think of a better picture for fixed income investments, I'm all ears

Let’s go over some bond terms.  First, the issuer is the entity selling a bond.  This can be a company, or a government.  The coupon is the bond’s interest payment.  For corporate bonds, this is usually made twice annually.  The maturity date is the date on which the issuer must repay the initial borrowed amount.  The par value, also called face value, is the amount repaid at maturity.  If the issuer cannot repay the face value or make interest payments, the company is in default.  Bonds will still have some value, as creditors (bond holders) have a claim to the issuer’s assets.  Which companies are more likely to default?  A credit rating for a bond issuer is just like one for a person, it measures the issuer’s ability to repay a loan.  Higher credit quality investments are less risky.

Why would a company sell bonds to investors instead of taking out one big loan from a bank?  Simple: it’s cheaper.  Because bonds are small amounts that are easy to buy and sell, it increases the number of investors willing and able to purchase them.  A larger pool of potential buyers effectively bids down the interest that a company has to pay.

So what does all of this mean for you?  The steady payments made on bonds make them a less risky investment than stocks.  Small investors usually don’t buy individual bonds, but they can invest in bonds through bond funds.  I’ll cover different types of funds, including bond funds, in later issues.

Tags: bond, credit, investments, money

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