What is a Bond?

What is a bond?

What is a Bond and How is That Important?

A bond is simply a debt instrument or IOU issued by a government (federal, state, and/or local in the United States) or a corporation.

But before we go into the nuts and bolts of bonds, let's consider a couple of other "big picture" issues.

When it comes to savings and investing, you really have only two choices of where to put your money - debt or equity.

Bonds are obviously debt. And, indirectly at least, so are deposits made in savings accounts, money markets, and CDs.

Consider how those deposits are used. That money is essentially loaned back out to other individuals or businesses (and sometimes it's used to purchase government bonds).

Stocks, on the other hand, are equity, or rather they grant you a claim to a certain portion of a business's equity and, in turn, its profits.

If you use your money to start your own business, or if you buy real estate in the capacity of a landlord, those are both forms of equity investing, or investing for profits.

So there you go - if you're going to save or invest money, there are really only two categories of choices - loaning your money or investing in (potential) profits.

Understanding this brings a certain clarity to the process. The details of individual savings and investment options are important, of course. But it's just as important, if not more so, to understand the structure of economics, and how things really work.

And here's the important epiphany - when it comes to lending vs. borrowing, it's much better to be on the lending side than the borrowing side.

However, the simple fact is you (or your kids) are never going to get rich loaning money to other people.

What is a Bond - An Overview

Typically, a bond investor receives regular interest payments on a semi-annual or quarterly basis.

Unlike a savings account, or some CDs, the interest is not reinvested or compounded in any way. It's simply paid out to the bond holder at a set interest rate.

Bonds have fixed maturity dates. That means at some point, the bond will "come due" and the bond issuer must return the original principal amount back to the bond holder.

But until that maturity date, the only payments made are interest payments, so in that regard, bonds are unlike regular installment or amortized loans (i.e. car loans, home loans, etc.).

How Much Interest Do Bonds Pay?

There's a lot that goes into determining how much interest you'll receive from purchasing a bond:

• Prevailing interest rates in general
• Credit quality of the bond issuer
• Price of the bond itself

Most of this is common sense. If interest rates in general are low, bond rates are going to reflect that. And governments and corporations are just like people - the higher their perceived credit risk, the higher interest rates they're going to have to pay to service their debt.

But there is one other unique aspect to bonds that needs to be understood. And that involves the relationship between their price and their yield.

Bond Prices and Yields

In an ideal world, a bond's price would be constant and everything would be simple.

A bond does have what's called a par value, which is the principal amount that the bond issuer will return to the bond holder when the bond finally comes due.

Like stocks, bonds are also traded on a secondary market. And they do not always trade at the par value. As a result, the yield you receive on a bond may not match the stated interest rate of the bond itself.

An example: Suppose a bond with a par value of $1000 pays a 10% interest rate. That means the bond holder would receive $100 a year in interest payments.

But what if the bond traded below par value and you were able to buy it for only $900? The interest payments would still be $100 a year, but because you paid less for the investment, your actual yield would be 11.11%.

And then, if you held the bond until maturity when the bond issuer was obligated to retire the bond, you would receive the $1000 par value of the bond which would result in an additional 10% return on your original investment.