Bond - What is a bond?
In finance, a bond is a formal investment contract in which an investor loans money to an entity or corporation for a fixed period of time, at a fixed interest rate.
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A bond is the written agreement that requires the entity which is borrowing money from the investor to repay the bond holder the principal amount at maturity plus the stated interest.
How do bonds work?
A bond is essentially a loan, so think of it as a form of long-term debt. The party borrowing the money is called the bond issuer, and the party investing or lending the money is called the bondholder.
In other words, when you buy a bond, you are basically buying a loan which means you are lending money to someone else, making you the bondholder. In return, the bond issuer will pay you interest for the length of the loan. How much and how often these payments are made is dependant on the terms of the bond. And at the bond’s maturity date, the issuer will also repay the principal or face amount.
Examples & advantages of bonds
There are a number of different uses of bonds. Typically, bonds are used by corporations and municipalities. For example, corporations use bonds to raise money for expenditures and acquisitions, and municipalities use bonds for fixed asset expansion to build new infrastructure.
For companies, bond financing has a number of different advantages. For example:
- Unlike equity financing, bonds can be issued without diluting the value of existing shareholders.
- Bonds offer a way of stabilising the company's finances.
- Provides easier and faster access to capital (as opposed to retained earnings).
- Bond interest expense is tax deductible (unlike equity financing).
- Offers the company an alternative to selling assets as a way to receive capital.
Characteristics of a bond
The basic characteristics and terms of bonds are the following:
- Coupon rate or yield: the interest rate, which the bondholder earns for loaning their money to the issuer.
- Coupon dates: the dates on which the bond issuer will pay the interest
- Face or par value: the amount on which the bond issuer pays interest on, and also the amount which is required to be repaid at maturity.
- Issue price: the original price which the bond issuer sells the bond.
- Maturity date: the date in which the bond will mature, and the bond issuer has to repay the bond holder the face value.
There are many different types of bonds, just to match your needs. Depending on what you are looking for, bonds will have different coupon rates, maturity dates, face values etc.
The original selling price of a bond will often be different from its face/par value. Depending on whether it is higher or lower than the face value, it means different things. For example:
- If a bond sells for more than its face value, it is called a premium.
- If a bond sells for less than its face value, it is called a discount.
- If a bond sells for exactly its face value, it is just called par.
The market rate of interest for similar bonds, and the coupon rate of the bond, will determine the difference between the face value and selling price of a bond.