Bonds

Bond (reference)

What are bonds?

Bonds are one of the ways to borrow money for company's or government's needs. In case of using bonds, let's say a company issues bonds in which a number of investors each lend a portion of money needed. The company who issues bonds is called an issuer and investors, who lend the money, become bondholders.

Bond states the following:

• interest rate (coupon), that will be paid to investor. Usually, it's fixed and interest is paid twice a year;
• amount of loaned funds (bond principal). These funds are to be returned upon the bond's maturity.
• maturity date. Date, when bond principal is to be returned.

How bonds work?

Let's say you bought a bond (through a bank or a brokerage) with a nominal of $5000, an interest rate of 6% and a maturity of 5 years. You would earn $1500 interest for the next 5 years. At the end of 5 years, when the bond reaches its maturity, you would get $5000 back.

Bonds vs. Stocks or Debt vs. Equity

Stock (reference), share (reference)

The important difference between bonds and stocks is that bonds are debt, whereas stocks are equity. When one purchases stocks, they become partial owners of a company, which provides the right to vote in shareholder meetings and for a part of company's profits. If one buys bonds, they become creditors to the issuer (government or corporation). The advantage of being creditor is of taking fewer risks: if company goes bankrupt, bondholders would get paid before stockholders. On the other hand, bondholders are entitled to the principal plus interest only. They don't share any company's profits, in contrast to shareholders.

What are pros and cons of issuing bonds for companies?

Bonds are cheaper way to lend money, than borrow from banks, because the market may evaluate company's creditworthiness better then a bank. This means that company may borrow money at a lower interest rate by issuing bonds as compared to a bank loan.

Another advantage is that bond interest is tax deductible, whereas dividends on stocks are paid out of already-taxed profits. Moreover, if a company borrows then it may be considered as a healthy behavior and expected higher profits in future.

The negative side is that an excessive debt increases financial risks. Unlike dividends on stocks, company has to pay interest on bonds even in a year without profits. In addition, principal has to be repaid after bond matures.

Government bonds (government securities)

Unlike companies, governments can't issue shares. Hence, if governmental spending exceeds income from taxation, then they may issue bonds. Also central banks, e.g. in USA and in Britain, uses short-term bonds to regulate money supply: e.g. to decrease the money supply they sell bonds to the commercial banks and withdraw the cash received from circulation.

Books