In finance, a bond is referred to as a debt security that is used by the government and other corporate bodies to raise capital for the several projects they consistently engage in. Bonds are available for investment in the stock market and in this article, you will learn all you need to know about bonds.
Table of Contents
What is a bond?
A bond is a type of fixed-income security provided by an issuer(government, companies etc) to investors who are required to lend money to the issuer for a certain amount of time to enable them to become bond owners.
When an investor buys a bond, he is providing a loan to the bond issuer for a certain amount of time in exchange for interest payments and a return of the principal when the bond is matured. A maturity of a bond is usually the specific date on which the principal borrowed by the issuer of the bond from the investor is expected to be returned. The bond market is larger than the equity market when considering capitalization and it is also profitable to invest but you will have to understand how bonds work.
Keep in mind that many types of bonds exist and there are ones regarded as lower-risk investments(investment grade bonds) and those with higher risk. They can cushion the risk associated with riskier investments like stocks and they are a good way to earn a steady income on the side.
Things to note about bonds
- They are tailored to provide returns through fixed periodic interest payments and the return of the principal amount Known as face value upon maturity.
- They operate as an “I owe You (IOU)” document between the lender(investor) and the borrower(government/corporate bodies). The details on a bond are usually the end date of the bond where the face value is to be paid in full by the borrower to the bond owner, the terms of interest payment, the principal to be paid etc.
- They are means of raising money to perform projects such as infrastructure building, buying property or equipment, growing a business and even hiring new staff.
It is also important to note the key terms associated with bonds which are;
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Maturity
The date on which the issuer of the bond is expected to pay the face value loaned to him by the bond investors.
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Face value
This is the principal paid upon bond ownership by the investor, and the amount expected to be paid upon bond maturity. The face value is the basis of calculating interest payment rates but it is not affected by the interest payment made. Face value is also called Par.
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Coupon
The interest the bond issuer is expected to pay its bond owner. It is usually fixed.
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Yield
This is the amount of return or rate of return expected on a bond. Yield is variable and it is influenced by activities in the secondary market
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Bond’s price
A bond’s price is divided into bid and ask. A bid is the highest price a prospective bond buyer is willing to pay to buy a bond and the ask price is the lowest amount a bond issuer decides to sell a bond
- Other terms to note include Duration risk(how the price of a bond might change with fluctuations in market interest rates), and ratings which help to understand the risk involved in a type of bond.
Types of bonds
- Corporate bonds: These are bonds from corporate companies that seek to raise funding for their several daily projects. These types of bonds are subject to income taxes.
- Government bonds: Bonds issued by the federal government and are subject to only federal taxes
- Agency bonds: Agency bonds are issued by government-sponsored enterprises and the primary objective is to acquire financing for the project it is mandated to accomplish.
- Municipal bonds: These are the bonds issued by the state and local tiers to finance local projects
How to buy bonds
A bond’s pricing is the face value tagged to it and pricing is usually done in the secondary market. When bonds are priced higher than the face value, it is regarded to be a premium while a lower-priced bond is called a discount. Bonds are influenced by secondary market factors and pricing depends on the forces of demand and supply. If you are looking to buy bonds you should consider their rating and the market interest rate attached to it, this will inform the yield that can be made.
They can be bought when they are newly issued(directly from the issuer) but you will need to have a brokerage account, through a secondary market(broker), or by buying shares of bond funds(mutual funds and ETFs).