Bonds

DEFINITION of Bonds

Bonds are a contract between two parties. They issue bonds and investors buy them (thereby giving the people who issued the bond money).

WHAT IT IS IN ESSENCE

Bonds have a maturity date. This means that at some point, the bond issuer has to pay back the money to the investors. They usually come in two varieties: corporate and government. It depends on the type of institution you are lending to.

Large organizations sometimes need to borrow money. Just like people do. But unlike people, large entities such as corporations and governments can have a difficult time getting as much money as they need. They have to agree not only to pay back the amount they borrowed but also to return a bit extra. And it comes in the form of interest. One way to collect the money they need is to issue bonds.

The bond contains details of its interest rate, known as its coupon, from the outset.

Since your initial investment is returned to you after the period of the expiring (also called the maturity date), this is the only profit you can have from them. 

HOW TO USE

Bond values are set at a par, typically either $100 or $1,000. This represents the face value, or the amount that the initial investment will be worth at the bond’s maturity. Interest rates are a calculation of the credit status of the issuer and duration of the loan.

How long you hold some also comes into play. Bonds with longer durations say a 10-year bond, versus a one-year bond, pay higher yields. That’s because they are paying you for keeping your money in the longer period frame of time.

However, interest rates have the largest impact on bond prices. As interest rates rise, bond prices fall. That’s because when rates climb, new bonds are issued at a higher rate. That makes existing bonds with lower rates less valuable.

But if you need to sell your bond on the secondary market, before it matures, you could get less than your original investment back.