How Do Bonds Work? - A Quick Guide

ByVladana Donevski
December 22,2022

Just as we often resort to financial institutions such as banks to ask for a loan when we can't afford expensive purchases, businesses can also do it when they lack the capital to fund their operations.

However, instead of going to a bank to ask for a loan, most business owners opt for signing a bond with investors, not only because it allows them to borrow larger sums of money but also because bonds have longer maturities. 

At this point, you may be saying, “Hold on, what are bonds and how do they work?” Well, this article is all about bonds, so keep reading to find out.

What Are Bonds?

Simply put, a bond is a source of funding that companies obtain through the public through investment banking. Even though bonds are similar to loans since they both involve money borrowing and interest rates, one significant difference sets them apart. 

Unlike loans, which come from financial institutions and have short repayment periods, investment bonds come from individual investors or even other, larger corporations and have longer maturities.

But in essence, yes, bonds are a type of loan. When you issue bonds, you're committing to repaying the entire amount and paying periodic interest payments to the bond issuer. The payment of interest depends on the arrangement between the two parties, but they are often made twice a year, and the rate is lower than compared to an actual loan from a financial institution.

Understanding Bonds - How Do They Actually Work?

When companies or other entities like governments need to raise money to fund their operations or maintain ongoing ones, finance new projects, or simply pay existing debts that are about to mature, they may issue bonds directly to investors.

After the decision to issue a bond has been made, business owners present their case to investors, who decide if investing is a good idea after analyzing the company’s financial situation. If investors believe you're in a good position to pay the money back in the stipulated time lapse, they will purchase the bond and become bondholders.

Keep in mind that, after being issued, investment bonds can be sold by the initial bondholder to other investors. That means a bond investor is under no obligation to hold a bond all the way through its maturity date and can sell it on the secondary market whenever they want if they decide to do so. 

Bondholders may decide to 'resell' bonds if they believe they could increase in value and get gains on the sale. However, just as bonds could increase, they could also decrease in value from the original purchase, resulting in a loss of money for the investor.

If you have a good credit score, chances are that you will find an investor interested in buying your bond quite easily. Unlike other recognized investment opportunities like buying stocks, bonds provide investors with a predictable income stream that allows them to preserve capital while investing, which is why they are so popular among risk-averse investors. 

Characteristics of Bonds

You need to be familiar with certain concepts when dealing with bonds. Here are some of the key elements that you will find in every type of bond:

  • Face Value. Also known as the par value, it refers to the amount of money the bondholder will receive at the bond's maturity date; however, the par value isn’t actually the price of the bond, which is what most people struggle to understand at first. 

  • Depending on a w number of variables, the price of investment bonds can change over time before reaching maturity. When that happens, the bond’s price stops being the same as the face value.

  • When a bond trades at a price higher than its face value (for whatever reason), it is said to be selling at a premium, and when it sells for lower than the face value, we say that it’s trading at a discount.
  • Maturity date. This is the term used to refer to the deadline for the bond issuer to pay the face value of the bond to its holder.

  • Coupon rate. Always expressed as a percentage, it refers to the nominal interest rate a bond issuer agrees to pay to the bondholder each year until the bond matures. That means that if an investor agrees to a bond with a coupon rate of 6% and a face value of $1,000, they'll receive an annual interest of $60 during that period.

  • Coupon dates. The established dates on which the bond issuer will make interest payments to the bondholder. Although there's no rule for setting coupon dates, most bond terms usually include two for every year before the bond matures.

Now that you know the most important bond characteristics, we can talk about bond categories, so you’ll better understand the pros and cons of each type of bond.

Types of Bonds

There are four main categories of bonds: treasury bonds, government bonds, municipal bonds, and corporate bonds. Let's learn more about them.

Treasury Bonds

These are bonds issued by the US Department of the Treasury on behalf of the federal government. With this type of bond, you must pay federal income tax on interest, but the interest is generally free from state tax.

Most investors see these as the safest bond investment possible, mainly because they are backed by the US government, so the chances of not getting your money back are practically nonexistent.

Government Bonds

The Federal Government issues this type of bond to raise money to support its expenditures. Just like treasury bonds, one of the characteristics of bonds issued by the government is that they are considered zero-risk investments; however, most are taxable at the federal and state levels.

Municipal Bonds

Also known as munis, these are bonds issued by states, cities, and municipalities. Although they are not as safe as the two types of bonds mentioned earlier, municipal bonds bring tax benefits to bondholders, such as not having to pay federal taxes on the interest.

Corporate Bonds

These bonds are issued by both private and public companies. This type of bond can be either high-yield (higher interest rate & risk) or investment-grade (lower interest rates because the risk is lower). The interest you earn on corporate bonds is always taxable.

Final Thoughts

In conclusion, bonds are a type of security sold by corporations and government agencies to gather money from investors to fund their activities. They are similar to loans in that one entity effectively lends the funds to another, but the differences are in where that money comes from and how long it takes issuers to pay it back.

There are several different types of bonds that represent different opportunities for investors. Some are safer investments with lower interest rates, while others are riskier but with a much better interest rate and a higher possibility of getting significant gains out of them. Lastly, you can always hire an investment firm or a business loan broker to ensure you get the best value out of your business investment.

Can you lose money on a bond?

Even though bonds pay interest and are considered one of the safest investment options, you could lose some money if you don't do your homework and research the interest rates well and other relevant factors well. Even though the risks are smaller than in most other investments, it pays to learn about bonds before throwing your hard-earned cash at something.

How are bonds paid back?

Bondholders receive the face value of the loan back on the date stipulated in the contract. Apart from the face value, they will also receive periodic interest payments until the bond matures.

Is it worth it to buy a bond?

Definitely yes! Most bonds are almost risk-free, which is why they attract so many risk-averse investors. That said, they can also be high-risk/high-reward investments if that's what you're looking for. 

How does the bond market work?

Buyers and sellers trade debt securities with one another in an organized and secure market. Bond prices are determined by the supply and demand for bonds and the perceived risk that each security carries. Depending on market conditions, investors will purchase bonds at prices that may be lower or higher than their face value.

How do bonds work, in a nutshell?

Bonds are essentially loans made to an entity, usually a government or corporation. Investors in the bond market lend money to the issuer for a set period at a fixed interest rate. The issuer agrees to pay back the loan on the maturity date and make periodic coupon payments before then. When investors purchase a bond, they effectively buy the right to receive these coupon payments.

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