What Is a Bond?

Tuesday, 26 Oct 2010 12:08 PM

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When you borrow money from someone, you give a promise to return the amount after a period of time. In some cases, such promises are made on a piece of paper, which details the time period for returning the money, and the interest to be paid, if any. When such debts are taken by businesses, they also sign such a promissory note, which is called a bond. 
 
Consider the following about bonds:
 
· Put simply, a bond is a loan agreement between its issuer and the investors, or those giving the loan, which details various terms such as tenure of the debt and interest rates. Through the issuance of bonds, companies may raise debt from individual investors and financial institutions such as mutual funds and pension funds. When compared to stocks, bonds are considered to be low-risk investments.
 
· When bonds are purchased by the investors, they are promised that the issuer will return the money with the applicable interest payments at a pre-determined date. In bond issuance, the interest rate is called 'coupon,' while the date on which the debt has to be returned is known as the maturity date. 
 
· There are many types of bonds available, based on the types of issuers and the way the interests are paid. The bonds can be issued by the government, local administrations such as municipal corporations, government departments, and private institutions includingcompanies. Government bonds, issued by the government, are known as treasury bonds.
 
· The U.S. government's treasury bonds are generally fixed-rate debt securities and the interest payments are made to the investors semi-annually and are free of any non-federal taxes. At the time of issuance, treasury bonds are sold through auction, but are later also available in secondary markets.
 
· Another popular category of bonds is the fixed-rate bond. As the name suggests, the coupon or interest rate remains unchanged for such bonds for the entire lifespan of the bond. On the other hand, floating-rate bonds have interest rates that keep on changing according to the market trends. In most cases, interest rates on such bonds are reviewed once a month or once a quarter.
 
· Interest rates are generally the primary criteria that attract investors to put their money into bonds. A bond with a higher interest rate is perceived to generate higher returns, in comparison to a bond with lower coupon or interest rates. However, the risks also increase with an increase in the interest rate. The higher the interest rate, the greater the risk for the bond investors. Therefore, the fundamentals of the issuer, and those of the particular bond, should be studied carefully, and the interest rate should not be the only criteria for investing in bonds.
 
For risk-averse investors seeking to invest in bonds, there are bond funds available on the market. A bond fund invests in various bonds and other debt securities and therefore the risk gets spread out, rather than being concentrated on one particular bond.

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