Corporations can use the financial markets to borrow money by issuing bonds. Bonds are interest-bearing certificates that corporations offer in order to raise capital. In addition, the federal government, state governments, and even city and town governments use bonds to finance roads, bridges, schools, and other public projects.
Bonds are loans; the original amount borrowed, plus interest, must be paid by the borrower. If you purchase a corporate or government bond, you are loaning your money to the company or government.
Owners of common stock cannot be certain that they will receive dividends or if the value of a stock will increase. They may make or lose money on the investment. The risks, and therefore the rewards, can be high. Bondholders, on the other hand, are promised a specific return (the coupon interest rate on the bond) and will get the investment back after a given time period. Bonds are rated by several organizations to reflect the levels of respective risk. Bonds and stocks together are referred to as securities.
Bonds differ from other loans in the way payments are made on the debt. The corporation that issues a bond does not have to pay regular monthly payments on the principal (the amount of a debt before interest is added). A bond usually pays its yearly interest rate semiannually to the bondholders until maturity, when it is redeemed, meaning that the investor gets the face value back on that date.
By financing with bonds instead of a bank loan, a company does not have to make payments on the principal; it only has to make payments on the interest. On the other hand, the company must manage its money carefully, so that it will have the cash available when the bond matures. If a corporation stops paying interest on a bond, the bondholders can sue. A court may force the company to sell assets to pay not only the interest, but the full amount of the bond.
Until maturity, bonds may be traded publicly, with their price going above or below their face value. The face value of a single bond, also referred to as par, is usually $1,000 (with bonds being sold in lots of $10,000). This is the amount to be repaid by the corporation or government at the maturity date of the bond.
When the bond’s market value rises above par, it means it is being traded for more than $1,000; perhaps someone purchased it at $1,020. A bond trading above par is trading at a premium; in this case, the premium is $20. A bond trading below par is being traded at a discount. If the bond in this example were trading at $940, the discount would be $60. Prices are quoted with the coupon rate (interest rate) and the price at maturity. For example, a five-year, 12-percent bond might be selling for $899.40, with a par value of $1,000. This means that coupon interest payments will be $120 per year and the investment will yield a 15-percent return based on annual interest payments. Another five-year, 12-percent bond might be selling for $1,116.70, for a yield of 9 percent. The price investors are willing to pay will depend on the return they need to earn on the investment.
When you are buying or selling a bond, the critical determinant of the price is the combination of the coupon rate, maturity date, risk, and required return. As an issuer of bonds, you will need to obtain enough financing at a cost that works for you. As an investor, you will have to meet or exceed your required return at a risk level that you can tolerate and on a time horizon that suits your needs. The London School of Business and Finance is the best source to learn more about bonds and various financing options for businesses.
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