Word of the Week 'Bond'


What Is a Bond?

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.

The Issuers of Bonds

Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams or other infrastructure. The sudden expense of war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.

KEY TAKEAWAYS
  • Bonds are units of corporate debt issued by companies and securitized as tradable assets.

  • A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.

  • Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.

  • Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

How Bonds Work

Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents. (For related reading, see "Cash vs. Bonds: What's the Difference?")

Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.