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What Exactly is a Bond?

SmartMoney


Technically speaking, a bond is a loan and its holder is the lender. Who's the borrower? Usually, it's the federal government, a state, a local municipality or a big company. All of these entities need money to operate to fund the federal deficit, for instance, or to build roads and finance factories so they borrow capital from the public by issuing bonds.

Now for a little bond-speak. When a bond is issued, the price you pay is known as its “face value.” Once you buy it, the issuer promises to pay you back on a particular day, the “maturity date”, at a predetermined rate of interest, the “coupon”. Say, for instance, you buy a bond with a $1,000 face value, a 4% coupon and a 10-year maturity. You would expect to collect interest payments totaling $40 in each of those 10 years. When the decade was up, you'd expect to get back your $1,000 and walk away.

A key difference between stocks and bonds is that stocks make no promises about dividends or returns. A company's dividend may be as regular as a heartbeat, but the company is under no obligation to pay it.

When a company issues a bond, however, it pledges to pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity, you know how much you're going to get back (in most cases, anyway. Of course, as with any investment there are risks when purchasing bonds and there are no guarantees that interest payments will be made or that your principal will be returned to you. We'll discuss some exceptions later). That's why bonds are also known as “fixed-income” investments, they are intended to provide you a steady payout or yearly income. And although they can carry plenty of risk, the potential for regular income is what makes them inherently less volatile than stocks.

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