Introduction to Bonds
What are bonds?
A bond is a loan in the form of a security where the bond buyer (the lender) lends money to the bond issuer (the borrower). Interest payments are made at fixed intervals for a predetermined amount of time and then the principal (the original money borrowed) is paid back at maturity. The term "bond" is technically reserved for debt issues where the repayment term is more than 10 years. If the repayment term is more than 1 year but not more than 10 years then the debt is called a "note". If the repayment term is 1 year or less then the debt is called a "bill".
How are bonds issued?
The process for issuing corporate bonds is similar to issuing stock. An investment bank (or a group of investment banks forming a syndicate) underwrites the bond offering by buying the bond offering and re-selling them to investors. Government bonds, on the other hand, are typically auctioned off.
Why do companies issue bonds?
Most companies issue bonds in order to raise funds to fund projects that require capital. When a company decides it wants to raise money it has to decide whether to do it by issuing stocks or borrowing money by issuing bonds or getting a bank loan. The advantage to issuing bonds over stock is that the company doesn't have to give up any partial control of the company or give up a portion of profits. The downside is that they have to pay back the money, with interest. Having to make debt payments each month will lower the profits of the company as long as they have debt outstanding as well as possibly raise the risk that the company may fail due the higher expenses.
Why do people buy bonds?
Most individuals buy bonds because they offer a decent return with relatively little risk. But because bond prices can sometimes fluctuate a lot, some investors buy bonds because they believe the bond market will be going up and they can sell the bonds at a profit.
Who issues bonds?
- Federal government. These bonds, called "Treasury bonds", are government bonds issued by the United States Department of the Treasury and are used to pay for Federal government expenses that not covered by taxes.
- State and municipal governments. These are called "municipal bonds" or "muni bonds" for short. These are bond issued by a state, city, county, local government, or one of their agencies (like a school districts or airport).
- Corporations. Corporate bonds are issued to meet the long-term capital needs of corporations. Sometimes corporate bonds carry "covenants", which are conditions placed on the borrower in order to get the loan. For example, in order for a company to get money they may have to agree to keep a certain amount of cash on their balance sheet.