Definition: The certificate an investor receives when loaning a business or government money. Among the information printed on it is:
– the business or government that is borrowing the money
– the amount of the loan, which is usually $1,000
– the annual interest the borrower must pay each year (usually broken in half and paid every six months), expressed as a percentage of the amount borrowed. This is the investor’s rate of return.
– the date on which the business or government must pay back the loan
Example: On April 15, 2008, Wal-Mart issued 6.2%, 30-year bonds. While the information is not readily available, we’ll assume that each bond the company issued was in return for a $1,000 borrowed. The annual interest is 6.2%, meaning 6.2% of $1,000, or $62 will be paid to the bond holder each year, consisting of two payments of $31 made six months apart. On April 15, 2038, the owner of the bond will turn it in to the company and be paid $1,000.
Investeach explains: First, let’s associate the formal names that each of the bond’s components go by:
– the business or government borrowing the money: issuer
– the amount of the loan: face value, par value or principal value
– the annual interest rate to be paid on the amount borrowed: coupon, nominal rate or stated rate
– the date on which the loan is due to be paid back: maturity date or redemption date
A commitment for the bond’s entire term? Let’s say that you invest $25,000 in 25 10-year $1,000 bonds. In the 8th year something happens and you really need your money back. Are you stuck holding it for the last two years? Thankfully, no. The bond may be sold by the original investor if he or she doesn’t want to wait until the loan is due. Other investors will be interested in buying it because whoever acquires the bond receives the interest payments from that point forward. Of course, the owner will turn it in when the maturity date arrives and receive the face value in return.
Corporations vs. governments: The bond market is enormous. One of the reasons is that if governments wish to spend more than the taxes they collect (and raising taxes is impractical) they can’t sell stock as corporations can. How would we own the government, anyway? Could we buy enough shares in the US of A to control a Senate seat or two? Of course not. Therefore, governments can only acquire excess money they need by borrowing it via bonds.
Influences on market values: During their term, bonds don’t have to be bought and sold for their face values. Interest rates in the economy may change, causing companies and governments to offer new bonds whose rates may be higher or lower than an existing bond’s rate. *The rule is that when interest rates rise, the value of a previously issued bond will fall, and vice versa.* For example, if a person can buy a new $1,000 bond paying 7% because interest rates have risen recently, she wouldn’t be interested in paying the same for your existing 6% bond. She will be willing to buy it, but for less than $1,000, meaning you’ll lose money if you sell.
A second reason why the market value of a bond may change is that the company or government has become more or less stable than it was at the time the bond was initially issued. If a company becomes less stable, this raises the serious question of whether it will be able to make the interest payments or return the face value when the bond matures. Concerned investors may sell the bond for less than face value just to rid themselves of this risk!
Safety vs. return: Investing in bonds is generally much safer than investing in stocks. For one, the amount of money invested is returned to the investor when the bond matures. Second, the annual interest must be paid by the company or government that issued the bond, while stock dividends can be reduced or eliminated if a company is struggling and could benefit from keeping the dividend dollars in the company. Notice that from the corporation’s standpoint, issuing bonds is much riskier than issuing stock. Finally, if the company goes out of business, bondholders get in line in front of shareholders to be paid back what they invested. Whatever the cash the company gets when it sells off its assets (known as liquidation) is used to pay off bondholders. Unless they are paid off completely, shareholders don’t receive anything!
One might ask why all investors don’t shun stocks for the safety of bonds. The big reason: bonds have limited “upside”. Our example bond pays just 6.2% per year. It’ll take a long time to grow one’s wealth at this rate. It’s a far cry from the chance to own a winning stock that doubles or triples in a couple of years.
Obligation vs. guarantee: Recognize that while a company or government is contractually obligated to pay interest and the face value back at maturity, this is not a guarantee. It may be in such bad financial shape that it is simply unable to pay what it owes. It may go out of business or reorganize and in the process pay bondholders only a fraction of what they’re owed.
Riddle me this:
1. What are the four critical aspects of a bond?
2. What is the dollar amount of interest the owner of a 5.5%, 10-year, $1,000 bond will be paid in one year?
3. Why would someone buy another person’s bond?
4. How many times per year does the typical bond pay interest?
5. What are the two major influences on a bond’s market value as it passes between buyers and sellers during its term?
6. When interest rates go up, what happens to the value of a previously issued bond?
7. With regard to raising money, why are governments different than corporations?
8. Identify three reasons why investing in bonds is safer than investing in stocks.
9. Identify the one big drawback to owning bonds.
10. Identify a reason why investing in bonds is not risk-free.
Also known as: Debenture.