If you’re a currency trader, stock trader, a fixed income investor, an investor in the commodities market, the real estate market, or if you just want to keep up to date with the status of your economy and or foreign economies, then it is really important that you have an understanding of what a bond is. Bonds play a very important role in helping all aspects of an economy function. Various forms of entities in both the public and private sectors use bonds.
Entities like city governments, county governments, governments that operate in territories, state governments and even governments that run entire countries make use of bonds. Entities like companies, who operate in the private sector also use bonds. Bonds are used frequently, all around world. If you are unsure as to what a bond is, then you’ve made it to the right place. Below I will explain what a bond is and why it is important.
What is a Bond?
A bond as it pertains to finance, is an instrument of debt taken on by a borrower (also known as an ‘issuer’) who contracts or promises to repay in full the capital (usually currency or other types of money) borrowed plus any interest, if any, back to the lender (also known as the creditor: the holder of the bond). The reason why a company, a government or any other entity would issue bonds, is because either that entity has insufficient capital to function or accomplish its objectives or the entity wants to build a reputation as a reliable and trustworthy borrower. Most of the time entities borrow because they have insufficient capital to operate effectively.
No matter the reason, issuers of bonds intend to raise capital by borrowing it from others and promising to repay it back in full plus any interest. The bond itself can take the shape of physical paper or a digital file that is documentable proof of the transaction.
When it comes to a borrower paying back the lender, it usually works like this. Usually payments are issued from the borrower to the lender at agreed upon intervals of time until the full debt is paid, interest included. When a bond is fully paid off by the borrower in the allotted time agreed upon by both parties, it is said that the bond has reached maturity.
The amount of interest paid to the bond holder on an annual basis is called the coupon rate. The coupon rate is agreed upon by both parties involved before the transaction takes place and is usually represented as an annual percentage based on the face value on the bond. Loans operate in a similar fashion because the interest rate of a loan is represented as an annual percentage based on the face value of the loan.
In fact, a bond is very much like a loan. Besides a few key differences a bond and a loan are exactly the same. Some of the key differences are: Bonds holders can trade or transfer ownership of the bond to other investors in a market. Loans typically cannot be traded to others. A bond typically is issued by a variety of entities to a variety of other entities. A loan usually occurs between commercial banks and average consumers / small businesses.
Let’s say “Government A” needs to borrow one hundred million United States dollars to help fund its operation. One way to find lenders to borrow from is to issue bonds. Since “Government A” is in fact a government, the bonds issued would be called “government bonds” or “public bonds” because governments are public entities. Public bonds can also be thought of as public debt because the public is ultimately responsible for paying the debt. So “Government A” would have to issue one hundred million dollars worth bonds to fully fund itself. But lenders aren’t going to just lend for the sake of lending. Lenders want incentives. A lender is going to say to one’s self, why should I lend to “Government A”? What’s in it for me?
That’s where the coupon rate comes in. “Government A” can offer an enticing coupon rate (interest rate) to persuade lenders to lend the capital needed. Let’s say “Government A” offers a three percent coupon rate for its bonds. That would entice lenders to consider lending to “Government A” because lenders would make three percent profit every year for their investment. But the next question that will pop into lenders’ heads is: “How long will it take for ‘Government A’ to pay me back plus the interest?” That’s a good question. The longer it takes “Government A” to pay back lenders, the less likely a lender would want to lend.
So “Government A” is going to have to set a maturity date – a date where full repayment of capital is due, interest included. “Government A” is going to want to chose a date that is not too far off, for that will discourage lenders; nor is “Government A” going to choose a maturity date that is too soon, for that will strain “Government A” into making larger payments and increase the risk of defaulting. If you’re not sure what “defaulting” means or what it means when a bond goes into “default”, allow me to briefly explain it to you.
When a bond goes into default, it means that the borrower has either missed a scheduled payment due to its inability or unwillingness to pay, breached the terms or conditions of the bond agreement or made changes to the terms or conditions of the bond. When an issuer of a bond defaults, it damages the trustworthiness and creditworthiness of the issuer, making it harder and more expensive for the borrower to get willing lenders in the future. As you can imagine, that is a bad thing.
Do you see why making bonds mature too quickly can potential be dangerous for the issuer? The borrower would have to make larger payments to the creditor in order to pay of the debt quicker. If the payments become to large, the borrow would have to miss payments which would result in a default.
Let’s say that “Government A” chooses a maturity date of three years. That means “Government A” plans to fully pay off it’s lenders plus interest (3% per year) three years from the bonds’ issue date. Now lenders should be excited to offer capital for “Government A”. But another factor that can influence lenders’ willingness to lend capital is the frequency of payments. The more frequent an issuer of a bond agrees to make payments to a creditors, the more enticing a bond becomes. However, if payments are scheduled to frequently, it increases the probability of default. For this example, “Government A” decides to schedule payments to bond holder once every quarter (three months).
Here’s the recap of this very long example. “Government A” bonds have the following features…
- A three percent coupon rate.
- A maturity date of three years.
- Schedule payments are once a quarter until maturity.
With terms like this, many lenders may be interested in lending money to “Government A”. However, if “Government A” is having trouble getting lenders, then “Government A” may have to adjust its terms so that its bonds are even more enticing without the bonds becoming overly burdensome.