Bond | Definition

The three main types of bonds are corporate, government, and municipal.

When corporations wish to raise money to expand their operations, two different methods can be used, equity and debt. The company can issue additional shares to shareholders to increase capital or issue debt in the form of corporate bonds to receive the same amount of money. 

Although this procedure may seem simple, when it comes to dealing with bonds, the process can become a little more complicated as there are many different types.

Definition of Bonds

A bond is a fixed financial instrument that companies and governments use to raise money for their operations. It is issued when a corporation or the government does not wish to give equity. 

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How Bonds Usually Work

When thinking about common, basic bonds, the bond issuer discloses a couple of factors, and it is essential to know what they mean. 

Principal Amount

When buying a bond, the principal amount is the financial instrument's price being issued. Depending on the issuer, the principal amount will vary.

Bond Coupon Rate

The coupon rate is the bond's interest rate, and it is used to determine the value of the interest payments that will be made over time. 

To attract investors, the issuer may vary the interest rate to make the financial instrument more appealing. For example, suppose the company issuing the financial instrument has a high credit rating, meaning they are reputable. In that case, they may have a higher yield, or a premium, to increase the upfront amount of money they receive.

On the other hand, companies that may not have extremely high credit ratings may opt-in for a lower interest rate or discount to account for the higher risk.

Coupon Dates

One of the main benefits of bonds is their periodic interest payments. Typically, these financial instruments pay interest on a semi-annual or annual basis, and the dates where the money will be given to the investor are disclosed.

Maturity Date

Lastly, the final piece of information that the issuer discloses is the bond's maturity date. The maturity date is the day that the investor will receive their initial investment (principal amount) alongside the final interest payment. Depending on the type of bond, the maturity date can range from one year to 30 years. 

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Different Types of Bonds

Corporate Bonds

Corporate bonds are utilized by companies who do not wish to issue additional shares for more money. Instead, they issue corporate financial instruments while disclosing the different factors mentioned above.

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Government Bonds

Secondly, the federal government issues financial instruments to the public when they wish to receive capital to benefit the community. For example, the government wishes to build playgrounds throughout each state to promote kids going outside and being physically active. However, it will cost a large sum of money to contract construction companies. Thus, the government has two options: using financial instruments or the Federal Reserve to receive the necessary capital. 

Typically, the government chooses to sell financial instruments instead of using money in the Federal Reserve as the influx of money being spent on a major infrastructure project may, most likely, cause inflation. 

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Municipal Bonds

Lastly, municipal bonds are issued by states and local governments when they wish to raise capital. Similar to the explanation of government variation, these municipal financial instruments are utilized when the local government needs funding for local projects, such as building a library.

Advantages of Bonds

When thinking about long-term wealth, most people usually think about the stock market, as the market typically rises in value over time. However, some people overlook the bond market and its advantages. 

The first main advantage of investing in bonds is there is minimal risk. When investing in a company via the stock market, the stock price is correlated to its performance. If a company begins to underperform, its stock price will take a hit and impact one’s investments, similar to Netflix after they announced they were losing subscribers.

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Bonds, however, are typically issued by the government and are viewed as having virtually no risk, as the federal government has an extremely low chance of defaulting. As government investments are viewed as risk-free, this essentially means that over time, an investor will receive passive income in the form of interest payments and the principal when the bond reaches maturity. 

Therefore, this type of investment benefits those who do not wish to invest solely in the stock market, wish to diversify their portfolio, or are risk-averse investors.

Disadvantages of Bonds

Although the risk-free benefit of bonds may be appealing to some investors, one of the main disadvantages is the fixed returns. Unlike investing in the stock market, when an investor puts money into these financial instruments, the return they will receive in the future will not change. As a result, the restricted return makes it challenging for investors to obtain a high yield, similar to investing in stocks.

Regardless of the type of investments one makes, there will always be some form of risk involved. Although the risk of bonds is lower than crypto and the stock market, it is crucial to always do research on the company that you decide to invest in. 

Regardless of how safe an investment may seem on the outside, you can be putting yourself and your money at risk without proper due diligence. Therefore, irrespective of the type of investments you choose to make, always conduct thorough research before investing to minimize your risk. 

Disclaimer: The mentioned remarks regarding financial instruments are not considered financial advice. Should you invest in any company which offers these financial instruments, do your due diligence prior to investing. CapWay is not liable for any losses made from investments based on the above information.