Updated August 4, 2024
What is a Bond?
A bond is like a loan taken out by a company, government, or institution. Just like when a company sells its stock, they reach out to their investors in the financial markets for a loan in exchange for cash.
Key Ideas
- Face Value: This is the amount of money that the investor receive from the issuer at the time of maturity
- Coupon: The amount of money you will be getting paid every payment period, usually twice a year
- Maturity: This is the day your interest is paid back
Setting a Foundation
Just as you might need money for your new car, a down payment on a house, or even the fancy new man cave your partner reluctantly agreed to, companies also need cash to fund their operations and expand their services. To do this, they usually do one of two things: issue stock or issue debt. This is referred to as capital structure, the way a company finances its operations. Capital structure can be made up of a mix of loans, bonds, common stock, and preferred stock.
Capital structure refers to the way a company finances its operations and growth through a combination of debt and equity. A company's capital structure is typically made up of a mix of long-term debt, such as loans and bonds, and equity, such as common and preferred stock. The optimal capital structure for a company will depend on a variety of factors, including the company's industry, risk profile, and financial goals. A company's capital structure can have a significant impact on its financial performance and risk profile, so it is important for management to carefully consider the appropriate mix of debt and equity.
Understanding the Essentials
Keep in mind that there are two distinctions with anything related to bond investing. Bond characteristics either refer to the market or refer to the company. For example, a bond might have a coupon rate that the company pays periodically that is different than the current yield. This section will help in understanding the essentials of bonds before diving into the nuances of market involvement.
Face Value
Issuers initially offer bonds at their face value, which is known as par. For most bonds par values tend to be $1000, but sometimes an issuer may choose to set theirs higher. Additionally, treasuries (A form of US Government bonds) have minimum denominations of $100.
Coupon Rate
The rate paid out to investors at each payment period. For example a 10% coupon rate on a $1000 face value bond would pay $100 in interest annually. However, bond payments are typically semi-annual, meaning an investor woud receive $50 twice a year. Let's say July 1st rolled around and you are expecting a tidy $50 check from Proctor & Gamble. You walk down to your mailbox to check your mail but you find no check! Looks like P&G missed their interest payment! Known as a default, this is equivalent to a person declaring bankruptcy.
Maturity
The maturity date in a bond contract represents the date the face value is repaid back to the investor, signifying the end of the bond contract and the cessation of coupon payments. In addition to the repayment of face value, the issuer also makes one last interest payment.
What’s in it for me?
In short, bonds provide an option for people to invest hands-free. Since there is a high likelihood that a company pays their coupon, investors tend like bonds since they can know how much they’ll receive, and when they’ll get it. Through these interest payments, companies incentivize investors to buy their bonds. At the end of the bond term, the maturity date, investors can collect their initial investment back through the repayment of principal. Additionally, investors have the option to sell bonds at higher values on the open market. With Silo, you can use our wide variety of bonds to save up for a car, a down payment on a house, or even just for retirement!
With any investment, there is a downside. While investors do take on less risk than with the stock market, this leads to lower returns. Since payments are fixed and periodical, investors are not able to enjoy theoretically unlimited capital appreciation on bonds. Another disadvantage that is pretty specific to bond investing is the probability that issuer could default on the bond you buy. Known as credit risk, this is reflected in the credit rating a bond is assigned. The higher the credit rating, the lower the credit risk of the issuer. Finally, bond yields are a market of their own. The state of yields on any given day affect bond prices, mortgage values, and even the stock market!
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