Bond (finance)
A bond in finance is a type of debt instrument used by issuers, such as corporations or governments, to raise capital. When an issuer sells a bond, they borrow money from the bondholder, agreeing to pay back the principal amount at a specified maturity date along with periodic interest payments, known as the coupon. Bonds typically have a face value, which is the amount to be repaid, and they are often sold in denominations of $1,000. The most common types of bonds are corporate bonds, which are issued by private companies, and government bonds, which finance public expenditures. For instance, U.S. government bonds are backed by the country's credit, making them a low-risk investment, while municipal bonds, issued by local governments, often feature tax-exempt interest income. The bond market is dynamic and influenced by interest rate fluctuations, where rising rates can lead to falling bond prices and vice versa. Overall, bonds appeal to investors seeking a steady income stream, although the associated risks, such as the issuer's ability to repay, must also be considered.
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Bond (finance)
A bond is a type of loan where an institution, known as the issuer, borrows money and promises to pay it back to the bondholder at a specific time. The issuer pays interest on the bond at specified intervals and then repays the amount borrowed, or principal, on a specified maturity date. While there are a wide variety of bonds issued in the global marketplace, the two most common are corporate bonds and government bonds. Corporate bonds are issued by private companies and are generally fully taxable and secured by a combination of revenues and assets. Government-issued bonds are used to finance public infrastructure, defense, and the full spectrum of government spending. Bonds issued by the United States government are backed by the full faith and credit of nation. State and local municipalities issue municipal bonds to finance smaller projects of local interest. The interest income on municipal bonds is tax free.
Background
The history of finance and lending is as old as civilization itself. In fact, many scholars suggest that keeping the record of business transactions, loans, and interest led to the development of the first writing systems in the ancient world. Nearly five thousand years ago in Mesopotamia, rules pertaining to loans of grain and silver were etched in clay tablets known now as the Code of Hammurabi. Similar tablets from the ancient world include detailed financial transactions, myths, and laws. Scholars continue to unearth documents recording sophisticated interest payments, mortgage loans, and rudimentary limited partnerships. The sophistication of financial markets continued throughout much of the history of the ancient Near East.
Evidence of money lending is attested in the Hebrew Bible, which expressly forbids charging interest on loans. Later Jewish writings continued to develop various means of lending and finance. Scholars disagree on the nature of the ancient Greek economy, but writings from the classical period indicate various forms of lending with interest. In his Nicomachean Ethics, Aristotle considers profit from lending unnatural. Early Christian writings indicate hostility toward charging interest on loans. Known as the sin of usury, making a profit on lending money was forbidden by the Roman Catholic Church well into the eighteenth century. Investment contracts of various forms continued to evolve through the late Middle Ages.
Two significant changes in the late Middle Ages had a dramatic impact on the history of finance: the rapid increase of international trade and urbanization. As farmers and peasants began migrating to cities, local economies shifted, and the need for public infrastructure increased. Regulations on money lending began to loosen, and governments needed to find new sources of capital. Increased competition and warfare also drained government coffers and added to the need for alternative revenues. To support growth and defense, many governments borrowed from wealthy citizens or other governments and paid interest on the loans. This practice of financing government operations and debt through interest-bearing loans continues in the world financial markets of today.
Overview
A bond is financial product that is used to raise capital for the issuer and earn income for the holder. A bond has three important features: face value, maturity date, and an interest rate. Bonds are usually sold in increments of $1,000. The face value, or par value, is the amount of money that the issuer promises to repay at the end of the loan, on the maturity date. The interest rate, or coupon, represents the amount of extra money the issuer will pay during the loan period. Interest payments are usually made twice a year. For example, a bond with a $100,000 face value and a 5-percent coupon that matures in ten years will require the issuer to make two $2,500 interest payments, totaling $5,000, per year until maturity. When the bonds mature, the issuer then pays back the face value of the bond ($100,000 in the example above). The income stream generated from bonds is attractive for many investors, but not all investors hold bonds until maturity.
The majority of bonds issued in the United States are transferable. This means that after the initial sale, bonds can be sold on the secondary market. The bond market is highly volatile, and interest rates fluctuate constantly. There is an inverse relationship between bond prices and interest rates. As interest rates go up, the price of a bond will go down. Thus, a bond will sell at an amount below the face value, or at a discount. Bonds will sell above the face value, or at a premium, when the market moves in the opposite direction, such as when interest rates fall. Because the secondary market is highly competitive, bonds are valued in part by comparison to similar bonds available. Investors consider the total amount of money on their investment from the time of purchase until the money is returned on maturity date. The value of a bond is also related to the issuer’s ability to repay the loan—that is, the risk of default is factored into the bond price.
All investments carry some degree of risk, and bonds are no different. The safer the investment, the lower the interest an issuer needs to pay to borrow funds. Traditionally, bonds issued by the US government (called Treasury bonds, or just “Treasuries”) were considered the safest investment in the marketplace, but after the financial crisis of 2008 and the unprecedented increase in US debt, the credit rating and safety of US Treasury bonds has been challenged.
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