Bond Investing Guide 1: What are Bonds?
October 21, 2009
You have already learned the basics of stock trading and investing in our Stocks Tutorial and Guide. This time, let’s learn another financial instrument: Bonds.
What are BONDS?
In very simple terms, a bond is an obligation by the borrower (bond issuer) to pay the lender (bondholder) a specific amount of money at specified times in the future.
Like stocks, bonds are issued as a way of raising funds. If a company, for example, needs money to expand the business or to pay out loans, they can choose to use stocks or bonds to raise capital.
Stocks vs. Bonds?
A major difference between a stock and a bond is that stocks do not guarantee any future payment (dividend) while bonds have a known and specific payment in the future (coupon interest).
This means if you invest in stocks, you are not sure if you can earn by receiving dividends. Companies, even if they are profitable, are not obligated to pay dividends to their shareholders.
Bond issuers, on the other hand, are required to announce a specified coupon interest rate prior to the issue. This guarantees that bondholders will know how much they can earn in the future. If the bond issuer suddenly becomes unable to pay its interest obligations, it is said to be in default.
Bond Terms: FACE VALUE, MATURITY DATE, COUPON RATE
The face value of the bond is the amount of money the bond issuer borrowed and must be repaid at the end of the loan period. The face value is also called par value or principal.
The end of the loan period is called the maturity date. At the maturity date, the bond issuer is required to pay the total amount of the loan borrowed from bondholders.
The amount of money earned from a bond is determined by the coupon rate or interest rate of that bond. This is always announced prior to the issue. Most bonds pay semiannual (every 6 months) coupon interest, although there are some that pay quarterly or annually.
How exactly an investor earns from bond investing will be discussed in Part 2 of our series on How to Invest in Bonds.