Bonds

Definition

Bonds are debt securities issued by governments, municipalities, and corporations to raise capital. They represent a loan from the bond investor to the bond issuer, who agrees to pay the investor a specified interest rate over a predetermined period of time and to repay the principal amount at the bond's maturity.

5 Must Know Facts For Your Next Test

1. Bonds are typically considered less risky investments than stocks, as they provide a fixed income stream and a guaranteed return of the principal at maturity.
2. The price of a bond is inversely related to its yield, meaning that as interest rates rise, bond prices fall, and vice versa.
3. Bonds can be issued with different maturity dates, ranging from short-term (less than one year) to long-term (30 years or more).
4. Governments and municipalities issue bonds to fund public projects, while corporations issue bonds to finance business operations, expansions, or acquisitions.
5. Bonds are an important component of a diversified investment portfolio, as they can provide stability and income to offset the volatility of other asset classes, such as stocks.

Review Questions

• Explain how businesses use bonds to raise financial capital, and describe the key features of bonds that make them attractive to investors.
  • Businesses, including corporations and municipalities, issue bonds to raise financial capital for a variety of purposes, such as funding new projects, refinancing existing debt, or expanding operations. Bonds are attractive to investors because they offer a fixed income stream in the form of periodic interest payments (the coupon rate) and the return of the principal amount at the bond's maturity. Additionally, bonds are generally considered less risky than stocks, as they provide a guaranteed return and have a higher priority claim on the issuer's assets in the event of default. Investors can also benefit from the potential for capital appreciation if they sell the bond at a higher price than they purchased it for.
• Analyze how households, as investors, supply financial capital to businesses and governments through the bond market, and discuss the factors that influence their decision-making process.
  • Households, as investors, supply financial capital to businesses and governments by purchasing bonds. This allows them to earn a steady stream of income through the bond's interest payments, while also potentially benefiting from capital appreciation if the bond's price rises. Households consider factors such as the bond's credit rating, coupon rate, maturity date, and current market conditions when deciding to invest in bonds. A higher credit rating and coupon rate generally make a bond more attractive, as they indicate a lower risk of default and a higher return, respectively. The bond's maturity date also plays a role, as shorter-term bonds tend to be less volatile but offer lower yields, while longer-term bonds have higher yields but greater interest rate risk. Additionally, households may adjust their bond investments based on their overall investment goals, risk tolerance, and the prevailing interest rate environment.
• Evaluate the role of bonds in a diversified investment portfolio and discuss how the unique characteristics of bonds, such as their risk profile and income generation, contribute to the overall financial well-being of households.
  • Bonds play a crucial role in a diversified investment portfolio, as they can provide stability, income, and risk mitigation to offset the volatility of other asset classes, such as stocks. The fixed income stream and relatively lower risk profile of bonds make them an attractive investment option for households, particularly those seeking to preserve capital and generate a steady flow of income. Bonds can help to reduce the overall risk of a portfolio by providing a counterbalance to the higher-risk, higher-return potential of stocks. Additionally, the ability to sell bonds at market value before maturity provides households with liquidity and flexibility in managing their investments. The unique characteristics of bonds, such as their credit quality, interest rate sensitivity, and maturity, allow households to tailor their bond investments to align with their specific financial goals, risk tolerance, and time horizons, ultimately contributing to their overall financial well-being.

Related terms

Bond Yield: The annual return on investment for a bond, calculated as the ratio of the bond's interest payments to its current market price.

Bond Rating: A measure of a bond's credit quality, assigned by credit rating agencies, that indicates the issuer's ability to repay the debt.

Coupon Rate: The interest rate paid on a bond, expressed as a percentage of the bond's face value, which is paid to the bond holder periodically.