Bonds

Definition

Bonds are a type of debt security that represents a loan made by an investor to a borrower, typically a company or government. They are a financial instrument that allows the issuer to raise capital by promising to repay the loan with interest over a specified period of time.

5 Must Know Facts For Your Next Test

1. Bonds are a common way for businesses to raise long-term capital, as they provide a reliable source of funding compared to other financing options.
2. Households can supply financial capital by investing in bonds, which offer a steady stream of interest payments and the return of the principal at maturity.
3. Bond yields are inversely related to bond prices, meaning that as bond prices rise, their yields fall, and vice versa.
4. Bond ratings, such as those provided by agencies like Moody's and S&P, are important indicators of a bond's risk and creditworthiness.
5. The maturity of a bond, ranging from short-term (less than 5 years) to long-term (10 years or more), affects its risk and return characteristics.

Review Questions

• Explain how businesses can use bonds to raise financial capital.
  • Businesses can raise long-term financial capital by issuing bonds, which are debt securities that represent a loan from investors. By selling bonds, companies can access funds that they can use for various purposes, such as financing new projects, expanding operations, or refinancing existing debt. Investors who purchase these bonds become lenders to the company, and in return, the company promises to pay them a fixed rate of interest over a specified period of time, as well as the return of the principal amount at the bond's maturity.
• Describe how households can supply financial capital through investments in bonds.
  • Households can supply financial capital by investing in bonds, which offer a steady stream of interest payments and the return of the principal at maturity. Bonds are attractive to households because they provide a relatively stable and predictable source of income, especially compared to more volatile investments like stocks. By purchasing bonds, households are effectively lending their financial resources to the bond issuer, whether it's a government, municipality, or corporation. This allows households to earn a reliable return on their savings and contribute to the broader financial system.
• Analyze the factors that influence the risk and return characteristics of bonds, such as bond yield, maturity, and credit rating.
  • The risk and return characteristics of bonds are influenced by several key factors, including bond yield, maturity, and credit rating. Bond yield, which represents the annual income earned from a bond as a percentage of its price, is inversely related to bond prices, meaning that as bond prices rise, their yields fall, and vice versa. The maturity of a bond, ranging from short-term to long-term, also affects its risk and return profile, with longer-term bonds generally offering higher yields but also carrying greater interest rate risk. Additionally, a bond's credit rating, as determined by agencies like Moody's and S&P, is a crucial indicator of the issuer's creditworthiness and the bond's default risk, which directly impacts the bond's yield and price.

Related terms

Bond Yield: The annual income earned from a bond, expressed as a percentage of the bond's price. It represents the return an investor can expect to receive on their investment.

Bond Maturity: The date when the bond's principal is due to be repaid to the investor, at which point the bond's life comes to an end.

Bond Rating: A measure of a bond's credit quality, assigned by credit rating agencies, that reflects the issuer's ability to make timely payments of interest and principal.