The names bond, municipal bond. Bonds are some of the most necessary and fundamental vehicles in the financial sector. They allow towns, governments, companies and other groups to get funding. Bonds are essentially just IOU's to the person giving you money, the lender that says you're going to pay them back sometime in the future. There are a fancy form of a loan that gets companies and governments funding when they need it. What makes bonds different from loans is that there are a form of security in that you can buy a bond and start getting payments from the company that owes you. In essence, bonds are securitized loans.
Bonds will typically include an end date in their terms when the entire amount of money is due back to the issuer, as well as terms for the interest payments to be made. These are some core principles about bonds to remember if you're looking for a general overview.
Their corporate or government debt, issued by an organization that are tradable assets in the form of securities. Bonds are stable and referred to as a fixed income instrument. Their payments to holders don't fluctuate over time, like the value of stocks or dividend payouts due. Bond prices inversely correlate with interest rates. Since a low interest rate usually means the borrower is trustworthy, more people will want to own that bond because there's little risk. Conversely, high interest rates infer a risky borrower, which increases the chance that a bond will become worthless, thus making them cheaper. Bonds have dates, at which point all of their value must be paid back. This is called the maturity date, and beyond this point the bond ceases to exist. Like we mentioned before, bonds are a way for companies or governments to raise money without giving up ownership of their company, which is what selling stock would do. If a government needed money for a project, they could issue bonds, which investors can buy and be guaranteed payments by the government. Government bonds are typically seen as safe because there's little chance the government won't pay back the funds. Companies, on the other hand, go bankrupt Far more often, which would mean any bonds they issued would become worthless. If companies like Apple issued a bond, investors would eat it up because it would be seen as a very safe investment. However, if a company like Blockbuster issued a bond to raise funds to open up a new store, it would be a pretty risky bond. You might be asking yourself though, why wouldn't a company just go to a bank and get a loan? Well, chances are the bank can't loan them the amount of money they need. In this case, companies have to turn to selling bonds to raise more capital. Bonds provide a way for individual investors and funds to become lenders to massive companies. Think of it almost as a way of crowdfunding corporate or government debt. Finding one bank to give you $20 million might be hard, but finding 20,000 people to give you $1000 would be a lot easier. Now that we've covered why bonds exist and who issues them, let's talk about the specifics of how they work. ONS are a form of security just like stocks, except bonds are generally more secure and offer payments overtime and have an end date, which is how investors make their money. Rather than buying the stock at one price and selling it higher later. Bonds can be traded publicly or privately depending upon the way that they're set up. While you might buy a bond in a similar way as a stock, the difference is that bonds will come with terms and a plan for how you're going to get your mone. back. Bonds will include the terms of the loan, the interest payments to be made overtime, and the maturity date, the time at which the entirety of the funds need to be paid back to investors. Bondholders make their money through interest payments the company makes to them on top of paying back the original loan. Interest payments are called the coupon, and the interest rate is called the coupon rate. Most bonds are usually priced at either 100 or $1000, called the par value. However, prices can fluctuate as people buy and sell them. If a company issues a bond when their financials look good, but then something like, say a pandemic happens into the company loses all their revenue sources, the bond would fall in value as people wouldn't want to own it. However, since the bond was already sold to investors, in this case, it would be the investors who lose their money, not the company who issued the bond. This is the same way stocks and other securities work. It's the risk of investing.
The value of a bond depends on these main factors, credit, quality of the issuer's date until maturity, and the coupon rate compared to the average interest rate of other bonds. You could buy a bond in never plan to hold it until maturity. Rather, you could buy a bond to just flip it a few weeks later if the price went up. Conversely, you could also just buy bonds and let them sit, collecting interest over time and making your money back slowly. Let's go through some more specific principles of bonds.
Base value is the amount of money the bond is worth at maturity. A face value of 1000 would mean that at the maturity date the issuing company would have to pay you back the full $1000. The coupon rate is the interest rate which the issuer will pay a 5% rate on. A $1000 face value would mean that you'd get $50.00 per year in addition to the $1000 at maturity. Coupon dates are the dates when interest payments will be made. The maturity date is the end date of the bond and finally the issue price is the initial price the issuer set to buy the bond from them. The major determinants of quality of a bond are the credit quality of the company or government, like a corporate credit score, and the time to maturity. If the issuer has bad credit, the risk of losing all of the bonds value is greater, making the interest rate be higher in order for investors to be willing to take the risk. If the maturity date is further out, the interest rate will usually be higher too, since it will take a longer time to get back the initial investment. Companies get credit ratings from credit ratings agencies like Moodys and Standards and Poors. Side note, these companies were also one of the main reasons for the 2008 financial collapse, something we talked about in our blog on mortgage-backed securities linked right here. Bonds that are stable are called investment grade bonds. These are typically U.S. government bonds and strong profitable companies.
Bonds that are risky are called high yield bonds or junk bonds. These bonds have a greater risk of losing all of their value, which means they'll payout a higher interest rate, but you could lose everything if the company goes bankrupt. Main categories of bonds are corporate bonds, which are bonds from companies, municipal bonds which are bonds from states or cities. Government bonds, which are bonds issued by a National Bank, or government and agency bonds, which are issued by organizations that are affiliated with governments. There are also unique bond structures different from what we initially talked about. Those are 0 coupon bonds, which are bonds that don't pay interest but are rather sold at a discount and paid out in full at the end of the term. For example, you could buy a $1000 face value bond for $900.00 and in five years get back the full $1000. Convertible bonds are another type which can be converted into stock down the line depending upon the stock price. This allows companies to pay less interest to the bondholders that are willing to get stock of the company down the line instead of a higher interest rate over time. For example, a normal bond might have a 12% interest rate and a convertible and might have an 8% interest rate with the ability to be converted into stock. If the stock hits a certain price down the line, it's less payments for the company up front and could be an attractive risk to the bond buyer. There's also callable bonds, which are bonds that a company can buy back if they determined they can get a better interest rate down the line, say their credit rating improves in interest rates decline, the company could buy back the bond and reissue the bond at a lower rate. Finally, there's puttable bonds. These bonds allow the holders to sell the bond back to the company before maturity, which is a way for investors to protect themselves if they're worried about the company not paying up down the line. Lastly, let's talk about how bonds are priced. Bonds prices fluctuate just like any other security on the market. Just like if a company starts doing really well, their stock price might go U, so might their bond price. If a company starts losing a ton of money, their stock price might go down. So too might their bond price. All of it is a matter of supply and demand, what investors are willing to pay and what somebody's willing to sell it for. In reality though, there's a variety of technical factors that go into pricing bonds that we won't really delve into in this blog. At the end of the day, bonds are just loans to borrowers that individual investors hold. Not big banks necessarily. They can be fantastically stable investments that should make up part of your investing portfolio. They can also be radically risky investments that can make or break you. Bonds are at the center of the way our modern economy functions, and understanding how they work is crucial to understanding investing.
Comments
Post a Comment