Bonds: A Profitable Promise
When you hear the word bond in any context, you might imagine a contract, an agreement between two parties, or maybe even a promise of some sort.
Surprisingly, in finance, bonds represent a very similar idea.
Bonds are another popular financial asset that are mainly used by entities like banks, corporations, and the government. They are a low risk investment (even lower than stocks!) that usually guarantee positive returns.
But how are financial bonds related to promises? Well, bonds are essentially I.O.U contracts where an investor (known as the creditor) lends a set amount of money to another entity or person (the borrower), and expects to be reimbursed the amount they lent plus a set interest rate, known as the coupon rate.
Because a bond is a fixed-income asset, the creditor is paid back through periodic interest payment until the principal amount is paid by the maturity date (the date at which the loan must be completely paid off).
This maturity date allows bonds to be classified into three primary groups: short-term, medium-term, and long-term. Short-term bonds are bonds that mature within one to three years; medium-term bonds that mature in ten or more years; and long-term bonds mature in many years (typically around two or more decades).
Essentially, a bond is a legally-binding promise in which the investor says “Hey, I’ll pay you this amount of money to help you out, but you have to pay me back said amount with interest by this specific date.”
This should explain why bonds are lower-risk investments that typically have positive returns. The contract essentially ensures the creditor that they will not only receive their loan back in full, but also that they will make a profit due to the set interest rate specified in the bond contract.
After bonds are purchased firsthand by creditors on the primary “bond market”, they can then be sold among investors in the “secondary market” after their purchase, similar to the way stocks are bought and sold among investors.
It’s important to note that there is an inverse relationship between the interest rate of a bond and the price at which it is sold: as the interest rate rises, the issue (selling) price of the bond drops and vice versa.
But who uses bonds? Bonds are generally issued by four main types of bonds, each with their own specific characteristics: corporate bonds, municipal bonds, government bonds, and agency bonds.
Corporate bonds are bonds issued by companies or corporations in order to fund different aspects of their operations, such as construction or shipping. Corporations typically use bonds rather than bank loans due to lower interest rates and overall more beneficial terms.
Municipal bonds are bonds issued by states and cities to fund more local government projects whereas government bonds are bonds issued by the US Treasury. There are three main types of government bonds — bills, notes, and bonds. Bonds issued by the Treasury with a maturity of less than one year are known as bills; bonds issued with a maturity of one to ten years are known as notes; and bonds with a maturity of more than ten years are known as bonds. Agency bonds are bonds issued by different governmental organizations such as the Federal Home Loan Bank system.
Now, you not only know about the fundamentals of how bonds work, but also who they are typically used by. Overall, bonds are a great low-risk investment if you are looking to increase your chances of having a positive return on your investment.
