WHAT ARE BONDS?
10:30
- Bonds are debt instruments
- Bondholders are entitled to regular interest payments
- When bond matures, the entire face value of the loan must be paid back
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| Bonds Photo by Magele on Adobe Stock |
What are debts?
Before we get to bonds, we need to talk a little about debt in general. In a sense, all liabilities are debts—money owed to other people. Accounts payable, for example, is money owed to a company's suppliers. In a stricter sense, which we'll use in this course, debt refers to money borrowed in exchange for interest.
Types of Debts
Debt can either be secured or unsecured. Secured debt is backed by one or more assets. For example, a home mortgage is secured with a house. If the borrower fails to make interest payments, the lender has the right to sell the house to recoup the cost of the loan. Unsecured debt has no collateral. A typical example of unsecured debt is credit card. While credit card companies will charge an arm and a leg for missed payments, they can't seize any of your possessions.
What is a bond
A bond is a debt instrument that allows an investor to loan money—the principal—to an entity for a set period of time in exchange for interest payments. Unlike a traditional bank loan, a bond's principal is paid back as a lump sum at the end of the bond's term—its maturity date—instead of a little bit at a time along with the interest payments. Whereas stock represents ownership of a company, a bond represents money owed to a lender, or bondholder, with an obligation of interest payments until that money is repaid. In other words, a bondholder is a creditor, not an owner.
Although most bonds are unsecured, bondholders and other creditors get first dibs on the proceeds of a liquidation. Bondholders, therefore, have a better chance of recouping their investments than stockholders.
Why might investors who doesn't like to take too many risks—prefer bonds over stocks?
- Bonds are generally less risky than stocks —For risk-averse investors, bonds are a good choice. They exhibit much less volatility than stocks.
- Bondholders have higher liquidation claim —Indeed. If the worst should come to pass, bondholders are more likely to get something out of a liquidation.
- Bonds provides constant, periodic returns —Yes. for investors looking for consistency, bonds are the way to go.
But why would a company ever want to issue debt and have to pay interest? Isn't debt bad?
This might sound crazy, but it can often be the case that debt costs less than equity. For starters, equity costs control. While not required to pay shareholders dividends, Original owners of company would have to share ownership with the new equity investors.
There are also tax savings associated with debt that do not come with equity. And since company's board of directors answers to its shareholders, there's a cost of equity beyond dividend payments. Since equity is the riskier investment, the demands for stock appreciation and dividends can be a much higher cost to bear for a company than interest payments. Yes! Management that doesn't deliver the value expected of a company's stock might find itself out of a job.
Like stocks, bonds have a par value (also called a face value). This is the amount of money loaned to the bond issuer. We've already talked about this—it's the same thing as the principal. The bond's interest rate is sometimes called its coupon. When bonds are issued, they have a par value, coupon, and maturity date. In other words, investors will know how much they have to loan to the issuer, what interest payments they can expect, and when they'll get their money back.
The difference between stocks and bonds
| Bonds | Stock |
|---|---|
| Ownership of these means being a creditor of the issuing entity. | Ownership of these means ownership of the issuing entity. |
| These come with interest payments. | These sometimes come with dividends. |
| These have a higher claim in the event of liquidation. | These are generally the riskier investment (but with greater return potential). |
| These have a maturity date. |
Let's review the key terms we have mentioned so far.
| Terms | Explanation |
|---|---|
| Par Value | Loan amount also called the principal or face value |
| Maturity date | The time when the principal (par value) must be repaid |
| Coupon | The interest rate |
| Secured | Backed by a specific asset |
| Unsecured | Not backed by a specific asset |
We're well on our way to some basic bond knowledge. In the next lesson, we'll learn how an investor can trade bonds and the important numbers to look at when trading bonds.
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