Financial Bonds Made Simple
If you need a crash course on financial bonds, you’re in the right place.
In this post I’ll explain:
- What a bond is
- The components of a bond
- How bonds are issued
- How to buy bonds
Let’s jump in.
What is a Bond?
A bond is an IOU. It’s a paper that says, ‘So-and-so owes you money.’ So-and-so is usually a company or a government.
Whoever owns the bond is called a bondholder. Whoever issued the bond is called the bond issuer.
The bond issuer took out a loan. Now he must pay off that loan with interest. He makes payments to the bondholder.
A bond is a security that guarantees the debt will be paid. The company or government must honor the bond by paying money to the bondholder.
For example, if you own a treasury bond, it means you’re lending money to the U.S. Department of the Treasury.
Now the Treasury must make interest payments to you until the debt is paid off. The bond designates a time when the Treasury must fully pay its debt.
What are the Components of a Bond?
There are many different kinds of bonds. Some include more sections than others.
But almost all bonds have 6 essential parts:
1. The Principal
The principal is the amount of money on the bond. It’s the amount originally loaned. It’s also the amount that must be paid back.
A common principal amount for Treasury bonds is $10,000.
2. The Coupon (Interest Rate)
The coupon is the interest rate. It’s based on the principal amount. In our example, the principal for the Treasury bond is $10,000. Let’s say the interest rate is 4%.
The interest payment comes out to $400. In the case of Treasury bonds, they pay interest every 6 months. That comes to $800 dollars a year.
3. The Maturity Date
The maturity date is when the bond issuer pays back all the money. It’s the ‘due date’ for the loan.
Some bonds have a maturity date as early as one year. Others have a maturity date as late as 35 years.
4. The Yield
The yield is how much money the bond is producing in a year. In our example, our Treasury bond is giving us $800 a year.
5. The Market Price
You can buy and sell bonds. A lot of factors affect the price of a bond:
Who’s the bond issuer?
How much does the bond yield?
What’s the bond’s maturity date?
What are the prices of other bonds?
These variables affect the price of a bond on the market.
6. Credit Quality
There’s a chance that the bond issuer can’t pay the money back. That’s where credit quality comes in.
Credit quality analyzes a bond and says, ‘Yeah, the bond will be paid at the end’ or it says ‘No way this bond will be paid off at the end.’
Worried a bond issuer can’t pay what they owe? Check out the bond’s credit quality.
How are Bonds Issued?
There are a few ways a company or government can issue bonds.
In the case of government bonds, they are issued by an auction. The public, banks, and organizations can attend the auction and bid on bonds.
In the case of business bonds, they usually need the service of an external organization. They can go to a public authority, the government, an institution, or another company.
Typically a bond issuer will use the help of banks and security firms.
The organization will buy all of the bonds from the bond issuer. Then the organization will resell the bonds on the market.
After that, the bonds are in the hands of people like you and me.
How do I Buy Bonds?
There are a few ways to acquire bonds. Here are three options:
The U.S. Treasury Department – The Treasury has a website called TreasuryDirect. You can learn how to buy bonds there.
A Brokerage – There are online brokerages who sell bonds. You can view a list of brokerages here.
An Exchange-Traded Fund (ETF) – There are many kinds of ETFs, and one option is a bond ETF. This is a portfolio of bonds that are traded on the market. ETFs are usually managed by a broker.
There’s still a lot to learn about bonds, but that gives you a solid introduction to the subject.
Are you considering buying bonds? Do you have more questions about bonds? Leave a comment and let us know!