What Bonds Are, How They Work, & What They Say About the Economy

Bonds are loans made to large organizations such as corporations, cities, and national governments. An individual bond is a piece of a massive loan. That's because the size of these organizations requires them to borrow money from more than one source. Bonds are a type of fixed-income investment.

There are many different types of bonds, varying according to who issues them, length until maturity, interest rate, and risk. The safest are short-term U.S. Treasury bills, but they also pay the least interest. Longer-term Treasuries, like the benchmark 10-year note, offer slightly less risk and higher yields. TIPS are Treasury bonds that protect against inflation. Municipal bonds are issued by cities and localities. They return a little more than Treasuries but are a bit riskier. Corporate bonds are issued by companies. They are riskier than government bonds because corporations can't raise taxes to pay for the bonds. The highest paying and highest risk bonds are called junk bonds.

The borrowing organization promises to pay the bond back at an agreed-upon date. Until then, the borrower makes agreed-upon interest payments to the bondholder. People who own bonds are also called creditors or debtholders.

Of course, the debtor repays the principal, called the face value, when the bond matures. Most bondholders resell them before they mature at the end of the loan period. Bonds are either publicly traded on exchanges or sold privately between a broker and the creditor. Since they can be resold, the value of a bond rises and falls until it matures.

Imagine if the Coca-Cola Company wanted to borrow $10 billion from investors to acquire a large tea company in Asia. It believes the market will allow it to set the coupon rate at 2.5% for its desired maturity date, which is 10 years in the future. It issues each bond at a par value of $1,000 and promises to pay pro-rata interest semi-annually. Through an investment bank, it approaches investors who invest in the bonds. In this case, Coke needs to sell 10 million bonds at $1,000 each to raise its desired $10 billion before paying the fees.

Each $1,000 bond is going to receive $25.00 per year in interest. Since the interest payment is semi-annual, it pays $12.50 every six months. If all goes well, at the end of 10 years, the original $1,000 will be returned on the maturity date and the bond will cease to exist.

Source: What Bonds Are, How They Work, & What They Say About the Economy
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