In their simplest form, bonds are debt obligations.
A company or government can issue bonds in order to raise capital for a particular venture.
The company has therefore borrowed money and pays an agreed interest amount over time as payment.
Those who buy the bonds are known as ‘lenders’, and the bond or loan note is their IOU.
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Characteristics of Bonds
The face value (sometimes known as par value) of any bonds is the amount to be repaid once it reaches maturity.
Interest Rate or Yield
The yield of any bond is the amount of interest that bondholders (lenders) will receive from the issuer. This may be paid quarterly, semi-annually or annually.
In rare cases, bonds are issued without any offer of interest (zero-coupon bonds) but are sold initially at a discounted rate, with the idea being the lender makes their money at maturity.
This means the date at which the bond’s principal (the amount borrowed) must be paid back in full.
The timings differ for property, corporate and governmental bonds and range from a few months to 100 years.
The Bond Issuer
‘Issuer’ is the name given to the company issuing the bond and their stability is obviously the fundamental factor in establishing the risk of your investment.
Governmental bonds are obviously very low risk due to their nature, while a bond issued by a company with no proven track record may be risky.
Corporate bonds offer much better interest than governmental in order to balance out their risk.
How Do Corporate Bonds Work?
A company needing capital issues bonds, agreeing to pay them back at a certain date.
Fixed interest payments are agreed until the bond matures when the entire amount, the principal, is repaid.
The principal plus the total interest paid is known as the yield, which is the total return on investment.
Who Buys Them?
Investing in bonds is done by both private and professional investors, including pension funds, banks and insurance companies.
Government bonds, known in the UK as ‘gilt-edged securities’ are usually sold at auction to financial institutions who then resell them in the markets.
How Do Investors Make Money on Bonds?
The allure of any bond is its yield – the total return which is the sum of the interest payments added to the principal.
There are two ways of making money on bonds, the first of which is to simply collect the interest payments until the bond matures.
The second way is to sell the bond for more than you paid for it, before the point of maturity. By selling the bond through a broker it’s possible to make a capital gain depending on what has happened to the credit quality of the issuer.