What is a Bond and How Do They Work?
With stock market indices at all-time highs and corporate valuations reaching questionable levels, most investors are understandably looking for investments that can provide them with steady returns at minimal risk. Bonds represent the risk-off, flight to safety investing approach that many investors in the current investing landscape are searching for. So, what are bonds and how do they work?
Bonds are essentially debt instruments where a borrower borrows money from a lender in exchange for a fixed interest rate. You can think of bonds simply as loans. When governments and corporations want to raise money, they are able to do so using bonds. When you purchase a bond, you are effectively lending money to a specific institution in exchange for interest payments.
Bonds have different time frames that you can think of as lending periods. These lending periods represent how long the “loan agreement” will continue before the principal amount would need to be repaid. They can be as short as just a few weeks or as long as 30 years. Let’s look at a basic example to demonstrate how these debt instruments known as bonds function in practice.
Assume you decide to purchase a $1000 10-year government bond at a 5% yield. The $1000 would be your original loan amount, also known as the face value of the bond. The 5% yield would be the interest rate payable on that $1000 loan also known as the coupon amount. In this example, you would be paid $50 per year every year for the 10-year duration of the loan. The interest payments would either be paid in quarterly installments of $12.50 totaling $50 by the end of the year or in annual installments of $50. At the end of the 10-year loan agreement, the bond “matures” and the original $1000 is paid back. By this point, the individual who purchased the bond will have collected $500 in interest payments and have received their original $1000 back.
A bond is considered to have “matured” when the lending period has ended at which point the face value of the bond must be returned. It is therefore one of the primary considerations for investors when deciding whether or not to invest in any particular bond. However, the bond does not always have to mature in order for the lender to secure the return of their funds. Some bonds are capable of being paid off before maturing if the bond has a call provision. Usually, this will occur with corporate bonds and is done so at a premium and at the discretion of the company. Alternatively, lenders also have the option to sell their bonds on the open bond market. In doing so, they are able to recover the face value of the bond and discontinue receiving their interest payments.
Investors who choose to invest in bonds should be aware that whilst they are relatively risk-free, they are not entirely without risk. Bond investors are still exposed to the risk of interest rates increasing, the Issuer becoming unable to meet their financial obligations, and the risk of inflation rising higher and eating away at their interest payments.
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