What Are Bonds and How Do They Work?

If you have ever spoken with a financial advisor or read a general investing article, you know that most advisors believe you should put part of your money into bonds. But why?

Financial advisors love bonds because they are conservative, reliable investments that provide stability to any portfolio. But how exactly do they do that? Let’s take a look.

[VIDEO] What Are Bonds and How Do They Work?

What is a Bond?

A bond is debt instrument that a government or a company issues to raise money. Basically it is a contract between a government or a company—who is acting as the borrower—and investors like you—who are acting as the lender.

When you buy a bond, you are lending money to the government or company that issued the bond, and in return, the government or company that issued the bond is agreeing to pay your money back, with interest, at some point in the future.

Think of it this way. When you buy a house, a bank creates a contract—a mortgage in this case—wherein the bank lends you money and you agree to pay the bank back, with interest, at some point in the future. Well, with a bond, you are like the bank, the government or company is like the home buyer and the bond is like the mortgage contract.

Characteristics of a Bond

When most people envision a bond, they picture a certificate that states how much the bond is worth, the interest rate that will be paid out on the bond and the date on which the bond will mature, and they are exactly right.

Let’s take a look at the following characteristics of a bond:

  • Face value is the amount the bond will be worth at maturity and the amount the bond issuer uses when calculating interest payments.
  • Coupon rate is the interest rate the bond issuer will pay on the face value of the bond.
  • Coupon dates are the dates on which the bond issuer will make interest payments.
  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds.

Buying and Selling Bonds

Many investors mistakenly believe that once you buy a buy a bond you have to hold onto it until it matures. That is simply not the case.

You can buy and sell bonds on the open market just like you buy and sell stocks. In fact, the bond market is much larger than the stock market.

Here are a few terms you should be familiar with though when buying and selling bonds:

  • Market price is the price at which the bond trades on the secondary market.
  • Selling at a premium is the term used to describe a bond with a market price that is higher than its face value.
  • Selling at a discount is the term used to describe a bond with a market price that is lower than its face value.

 

Image courtesy Horia Varland.

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