Bonds - What is a Bond?

Summary: This article gives a brief description of what bonds are, who issues them and their role in the financial markets.

Related Articles: Bond Investment Basics, municipal bond funds , Corporate Bonds

Have you ever found yourself short of cash and wanted to buy something today? You tell yourself, if you just had a faster computer you could learn more and get things done much quicker, leaving more time for other productive activities. Ever borrowed the needed money then paid it back with interest, say by using a credit card?

So do most commercial enterprises. Like you, businesses have only so much cash - working capital - to buy equipment, pay for research and a thousand other items that could be used to improve productivity. Raising productivity lowers costs and increases their income (revenue).

When businesses need to borrow, though, they have more choices than the average person. Like you, they can get a straight bank loan - but they can also 'float stock' (i.e. issue shares of ownership in the business) or issue bonds.

Definition of a bond

How would you define a bond? It is 'a form of loan', made by bondholders to a company. They're issued with a fixed face value (usually in increments of $1,000), interest rate (the 'coupon rate') and maturity date.

The face value is what an investor pays to acquire them, receiving interest payments at specified intervals - traditionally every six months. On a certain (maturity) date, five years from the date of issue, or two, ten, thirty - the number varies - the initial amount (the 'principal') is paid back in full.

For various reasons - most of them associated with the vagaries of human interest in news stories - bonds are much less well known or understood by the average investor. Even so, the bond market is much larger.

The world total amount of outstanding bond debt has been estimated at $33 trillion, with the U.S. portion about half that. Much of that is government borrowing, who are among the largest issuers. The total equities (stock) market is roughly $20 trillion, with the NYSE (about 1/2 the U.S. total) at $8.5 trillion.

Comparing by daily trading volumes, US Treasury Securities alone are around $360 billion per day. The U.S. equity markets trade only around $50 billion per day. Both of these pale in comparison to the Foreign Exchange market that averages $1.5 trillion in transactions every day.

Bonds may get less press, but they offer investors several attractive features.

As a shareholder, the risk of loss of capital is much greater. In the event of bankruptcy, owners get paid after bondholders. Also, stock prices tend to be much more volatile - change more rapidly, more unexpectedly and with larger price swings.

Tax considerations play a larger role in bond investing. Many countries, states and municipalities issue bonds - often tax free. That means such interest payments received aren't taxed as, say, corporate stock dividends (or corporate bonds) are.

Bonds have the added advantage of having much more objective, calculable properties. Because of their inherent tie to general market interest rates and their set maturity dates, their future price and the worth of their present coupon rates in the future are safer to predict.

For example, if interest rates are currently 4% and the investor owns an 8% bond, that instrument will sell today at a much higher price than the original face value. Sorry, it's not quite so simple as double the original price.

The ability to calculate, with higher probability, the likely future value of bonds makes investing in them much more science and much less gambling art.