A bond is a fixed income instrument that represents a loan made by an investor to a company.
How Bonds Work
Oftentimes, companies need to raise cash for various business operations like buying new machines, building a factory, or developing new products. One of the ways companies can raise cash is by getting a loan from investors. The company will specify the loan amount they want to receive, the interest payments they will make, and the date they will return the borrowed money back to investors.
Investors who are willing to lend the company cash will receive bonds in return for the borrowed money. Bond holders are entitled to receive the fixed interest payments and repayment of the money as stated in the terms of the loan.
The company issues bonds and receives a cash loan.
The investor receives fixed interest payments and is returned the borrowed money on maturity date of the loan.
Normally companies will issue many bonds across many investors for the same loan. Typically, each bond represents a $1,000 unit of the loan. So if you own 2 bonds, you really own $2,000 of the larger loan.
Let’s look at an example.
Company XYZ needs $10 million dollars to build a new manufacturing plant. To raise this cash, the company seeks a $10 million loan from investors to be paid back within 10 years. In exchange for the loan, the company states it will pay 5% per year to investors and at the end of the 10 years will also return the $10 million it borrowed. To complete the process, the company issues 10,000 bonds to all the investors who agreed to lend them the money under those terms.
As a result, the company gets the money it needs to build its manufacturing plant and the investors become bondholders entitled to receive fixed income payments each year until the maturity date of the bonds.
It should be noted that it is not only companies that issue bonds. Cities and governments of different countries also issue bonds to raise money for things like road construction, building airports, and building schools. These are typically referred to as municipal bonds because they are issued by municipalities.
Why do people buy Bonds?
When you buy a bond you are lending money to a company. Like any other loan, the bond pays periodic interest payments and has a maturity date.
Investing in bonds is different from investing in stocks because as a bondholder you are lender to the company. Bondholders don’t have ownership in the company and don’t benefit from the company’s growth or profits. However, the company is contractually obligated to pay the bondholders fixed interest payment and return the money it borrowed, regardless if the company is profitable or not.
People buy bonds for the stream of income they can provide. So they seek to buy the bonds of financially strong companies they believe will not have any trouble making the fixed interest payments or returning the borrowed money at the end of the loan term. Buying bonds is considered an investment.
Where can you buy bonds?
Bonds are traded in the bond market. Depending on your broker, you may have access to buy individual bonds, however they usually require a bigger account size since the unit of each bond is $1,000. However, it is also possible to be invested in bonds via ETF which allows investors to buy bonds for lower dollar amounts.
Investors can invest in bonds via ETFs. At Metas Investments we help our clients do this to generate income. If you are ready to earn passive income or generate capital appreciation through bond investments, open an account with Metas Investments today.