Introduction to Bonds

Introduction to Bonds

When looking to raise capital for investments, one of the most popular ways for a company to do this is by selling a bond. Bonds are used extensively by the federal government to raise money, in which case they are known as treasury bonds, but that is a topic for another day.

Company Funding Options

Most companies have two main options to raising money for investments, either by selling stock or bonds. Depending where a company is in its life cycle, both can be good choices. Selling stock raises capital which does not need to be paid back, but it comes at a price of diluted ownership for the owners or current stockholders, and sometimes bonds are preferable. Instead of equity, issuing debt or bonds can be a good choice when the shareholders do not want to issue more stock, and the company is generating enough cash flow to service the bond repayments.

Commercial Bonds Defined

A commercial bond is a loan to a company, made by an individual, group of investors or another company. The loan brings in money to the issuing company which can then invest in additional assets, which may be new plant, materials or buildings to grow the company. Typically a bond is secured by a contract with the company which guarantees repayments on a set schedule over a period of time, which typically varies from 1 to 10 years.

Issuing bonds allows a company to loan money from a wide selection of lenders and investors, who individually may have been reluctant to take on the liability of the entire loan amount of the issued bonds total.

From the lender’s perspective, they do not get a return from the potential growth of the company (which may or may not happen, and may or may not be profitable), but they do get a fixed and guaranteed return on their loan, over a period of years.

Investors Asset Mix

Many investors like bonds because the return on a quality corporate bond is pre-determined, and is relatively low risk. This is in contrast with a pure equity investment which can be high risk, with no guarantee of return. To balance out an investment portfolio, many asset managers use a mixture of stocks and bonds in a portfolio to balance out potential risk. The actual percentage of each component varies, and with individuals depends on their risk tolerance. In most cases risk aversion grows with age, and many younger investors have a high percentage of stock for the potential capital appreciation and few bonds, whereas older investors nearing retirement often have a high percentage of bonds to guarantee income.

Bond Interest

The interest on a bond is fixed, and is more dependable than a stock investment.  The face value of a bond (sometimes called par value) is typically set at $1000, and the annual interest rate (sometimes called coupon) will be set at time of issue, with the maturity date (when the loan is due to be repaid) in a year or more. In practice the interest rate or coupon is typically paid semi-annually to the investors.  If the coupon rate is higher than the current market interest rates available to investors, then as long as the bond is relatively low risk, then it is an attractive investment, and potential investors will be willing to pay more than face value. Alternatively if better investments re available elsewhere, then investors will not be willing to pay the full face value of the bond and it will sell at a discount. Most bonds pay an annual interest rate, but in some cases. no interest is due to the end, and these are known as zero coupon bonds.