Bonds are debt securities/instruments that certify a contract between two parties, the bond issuer (borrower) and the bondholder (lender/investor). The investor lends the money to the borrower by purchasing a bond. The bond legally binds the lender into a contract where the lender must pay a certain amount of money to the bondholder at a specified/predetermined interest rate also known as the coupon rate and at pre-decided times (the coupon dates).
The lender/bond issuer must repay the principal (bonds' face value) once it matures. In other words, the issuer must return the bond's stated par value at the maturity date or the date of expiration. Bonds are mostly issued by entities like the government, corporations, municipalities and federal agencies. These are mostly issued to raise money for new projects and refinance existing debts. The interest rate on bonds can be both fixed and variable. However, they are mostly offered at fixed rates.
Some government and corporate bonds are traded publicly on exchanges while some are traded over the counter.
Instead of applying for loans from banks, corporations and other business entities often opt for bond issuance. These bonds are issued directly to lenders. The bond, when issued, states the interest rate and maturity date.
Generally, the price of bond issuance is set-at-par. This is either 100 US dollars or 1000 US dollars face value/individual bond. Here, it is important to understand that the real market price of the bond largely depends on the following factors:
Let's take a look at some examples of how bonds with fixed interest rates work:If the borrower issues a bond when the prevailing interest rate is 5 percent at 1000 US dollars par value and the annual coupon rate is 5 percent, then the bondholder will receive cash flows of $50 annually. In case the interest rate drops to four percent, the bondholder will continue to receive payments at 5 percent. This will make investing in bonds more attractive.
On the other hand, if the interest rate rises to 6 percent, the 5 percent coupon will no longer remain attractive.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!