What are bonds?
Bonds are one of a group of so-called “securities,” contracts used by companies and governments to raise money for their operations with an underlying asset as security. For companies, the company's goods, revenue streams and properties secure the bond. Government bonds are secured by future tax receipts.
Bonds and stocks are completely different animals. While stocks are equity, bonds are debt, secured by the assets of the company that issues the bond.
The language of bonds
Bonds come with their own unique terminology. The best way to start thinking about them is to view them in the same way as the debt you already understand, like a mortgage. When you take out a home loan, the underlying asset (the thing that will secure your loan) is the house and property on which the house sits. Your house is a security, and you promise to pay back the lender (who is investing in you) with a revenue stream: a portion of your income. Let's look at a few bond terms:
- Principal amount (also called face amount or nominal amount): How much was borrowed by the company or entity. The principal amount of your mortgage is the amount you borrowed from the bank.
- Term: How long from the initial borrowing to the final payout, when the bond has to be repaid. Most mortgages have a 30-year term.
- Maturity: The date that the bond will have to be paid back in full. Take the initial borrowing date and add the term, and presto! Maturity.
- Coupon: The interest payment. Bonds, unlike your mortgage, typically pay interest only until the bond matures, when it will pay back the principal amount.
- Coupon dates: How often payments are made. Your mortgage is probably paid monthly; bonds are usually paid every six months.
- Present value: What the bond is worth right now. This price is arrived at by bond math (great fun for finance geeks and eye-glazing for everyone else). It's basically the interest remaining, plus the principal, discounted according to an estimate of how likely the company is to default. This is approximately what you'd pay to buy a bond on an exchange.
Bonds are issued for the same reasons as stocks; because a company or government wants to raise more money than its operations, private investors and bank loans can support. Usually bonds are for a specific purpose. You've heard of “school bonds” and “road bonds,” issued by local governments to fund public construction projects. These are usually repaid using future tax revenue.
Corporations or utility companies may issue bonds to fund their own capital investments such as research and development or constructing new facilities. Federal governments may issue bonds to pay for operations (think wars and social programs) or to manipulate the money system.
How to buy bonds
Bond math is ridiculously complicated, but you can bypass most of it by buying shares in a bond fund, a pool of money invested in a wide variety of bonds. As with stocks, the market has already done the math for you. Most major online brokerages allow you to buy shares in bond funds. Buying individual bonds, however, is far more complicated; only very industrious investors would be advised to pursue individual bonds for their portfolios, as the investment requires a great deal of research.