What is a bond?
A bond is a debt issued by a company or government to raise funds from the public. Upon issuing this bond, the issuer is obliged to pay interest following certain defined guidelines such as interest rates and the frequency of payment among other things.
A bond is effectively a loan but contrary to a bank loan it is subscribed by many lenders instead of one. Along other means such as bank loans and shares, bonds are a medium through which an organization can raise capital to finance its expansion and/or operations.
There are many types of bonds with many different characteristics. They can be short, medium or long term. They can have fixed or variable interest rates. They also are not equal in regards to whom the issuer is.
For example a bond issued by the US government is safer than one that is issued by a small business. This derives from the fact that the US government has the means to pay back its due whatever the circumstances.
For that matter bonds are ranked along grades which are broadly either investment grade or speculative grade. The former signifies that the issuer of the bond is financially solid and the holder of the bond need not fear for his money. The latter means that there is an increased risk that the money lent would not be paid back.
Taking this into account investors generally ask for a higher interest rate when lending to less financially sound institutions. Thus, the safer the issuer the lower the interest rates he can borrow with and vice-versa.
To determine if a borrower is robust one has to skim through his finances. There are however rating agencies that investigate issuers, evaluate their finances and publish a grade where AAA is the highest rating and C is the lowest. Another grade used is D which means that an issuer is in default. In short it means that he did not pay part or all the interests and/or the capital borrowed when it was due.
In general an issuer borrows money for a certain period of time during which he pays interest and then pays back the amount originally borrowed at maturity. This period can range from a few weeks to a few years. When a bond’s maturity is shorter than a year bonds are usually issued at a discount and repaid at face value on maturity date. When the maturity spans over multiple years the borrowers pays interest every year and gives back the initial sum at maturity date.
Bonds can be traded before reaching maturity and can be sold to interested third parties. However their value might change and selling it before maturity can result in a loss or profit. The value of a bond varies according to the interest rates observed in the market. So if the Federal Reserve lowers its target rate the value of currently issued bond will rise because the rates they pay are higher. On the contrary if the central bank raises its target rate the value of outstanding bonds diminishes.
The bonds market comprises many issuers among them federal governments, cities and companies. Investing in bonds issued by the federal or local government is often given an advantageous tax treatment to encourage people to lend them money.
Contrary to stocks, bonds are deemed safer because when there are held to maturity the full investment is paid back. Bonds offer another protection regarding bankrupt companies. In case of liquidation, bond holders are paid back first, stockholders only come second.