How Do Bonds Work – Why Invest In Bonds
Having a general idea of what a bond is, let’s now take a more in-depth dive into the commonly asked question, how do bonds work?. Bonds are credits, which have maturity dates, once the maturity date of a bond is hit, the full sum of the debt must be repaid in full.
How Do Bonds Work?
Now that you know what a bond is, its easy to answer the question of how bonds actually work. Bonds can be issued by any organization or entity, but the most common type of bond that investors look to buy are issued by government organizations, or large corporate companies. The Treasury department will usually issue treasury bonds if they need money to finance certain operations undertaken by the government; this is a common practice among governments around the world. The same reasons apply to corporate companies when they are looking to raise capital as well. Instead of going to the bank to take out a loan, they will instead sell bonds to investors. In general, company bonds have higher interest rates than government bonds because of the inherently higher risk. Companies are more likely to go bankrupt than government entities.
So here’s a short example about how bonds work:
Corporation ABC needs to raise $150 million to finance an expansion project. To hit that amount of money, ABC is looking to offer bonds to investors. The maturity of the bond is fixed to be 2025. To make the bonds enticing to investors, the company needs to study the market interest rates and offer something that is in line with, if not above that amount. This bond will be made not only available to individual investors but to banks, funds, and other large corporations. Standard bonds come in denominations of $1,000 each.
Suppose ABC decided that a 10% interest rate is the interest rate to be offered, this means that if you bought a $1,000 bond contract, you will receive $100 (10% of $1,000) every single year as interest payout. You will continue to receive $100 every year until 2025 when you will receive your initial $1,000 back, with all interest as profit already banked.
It is also good to note that in between the period of time of purchase and maturity, the owner of the bond can actually sell the bond on the secondary market at its prevailing market price. The price of the bond is affected by the prospects of the company or the bond itself. Suppose ABC Company, a couple of years after issuing the bonds, did badly on the expansion project and are losing a lot of money. The bonds will likely go at a lower market price than the original $1,000 because of fears that it might go out of business. If a new buyer takes over the bond for $800, he is still entitled to the $1,000 maturity payout at 2025 as well as 6% of $1,000. Of course, if the company is doing very well and the interest rate of 6% is high compared to its peers, the bond price might go up in value. With how easy it is to open up a brokerage account today, buying bonds should be a piece of cake!