Bonds are essentially instruments used by the private and public sectors to raise capital either for investment or current expenditures (government bonds are primarily issued to fund current projects). A bond is a debt security, and in simplistic terms, could be described as the relationship in which one party issues a legally binding promise to repay, with interest, a lending party the amount that was borrowed. The bond issuer borrows funds from the bondholder, and guarantees that the amount borrowed will be fully repaid; because the bondholder assumes the risk of lending funds, however, interest is charged on the principal amount borrowed. The interest charges take the form of regular coupon payments which are a set and consistent amount of money. The relationship between the price paid for the bond and the bond’s assured coupon amount together act to establish the interest that the bondholder earns from the investment.
Coupon payments are made to the bondholder on either a monthly, bi/semi-annual or annual basis. After a predetermined period, the bond issuer ceases to pay the coupon (interest) instalments, and repays the bond’s principal/nominal amount. At this point the bond is said to have reached maturity, and the bond issuer has no further obligations to the bondholder.
A second factor influencing the interest charged on the principal amount is that the initial amount is subject to depreciation due to inflation: for the bondholder not to lose money through inflation induced depreciation, the total interest earned on the principal amount (the accumulated value of the bond’s set coupon payments) must at the very least equal the average inflation level for the period over which the bond was held. Whereas all bond issuers within an economy are equally affected by inflation levels, the risk component of interest rate determination is based on the creditworthiness of each individual bond issuer. The lower the creditworthiness of the bond issuer, the higher the amount of risk assumed by the bond purchaser, and in order to obtain investment, the issuer will therefore have to offer a higher bond yield (higher coupon values) to attract bond purchasers. Government bonds are generally considered as having no risk, and have lower (but guaranteed) yields than junk bonds (high risk bonds with necessary high yields).
Bonds are long term investments: all instruments, including certificates of deposits and commercial paper, which repay the lender within a year, are called money market instruments. Short term bonds (which are repaid anytime during the period of between one and five years) are often referred to as “bills”; medium term bonds (bonds that reach maturity during the period of six to twelve years) are “notes”; and long term bonds (bonds reaching maturity after twelve years are, expectedly, referred to as “bonds”.
Private companies and corporations may also raise investment funds by the issuing of stocks to current and new stockholders. The primary difference between stocks and bonds resides in the method through which investors earn returns on their investments. Whereas bondholders earn interest on their nominal investment, which is repaid when the bond comes to maturity, stockholders are given an equity share in the company. Stockholders therefore own part of the company in which they have invested, and do not receive a repayment of their principal investment: instead, stockholders earn dividends of the company’s profits based on the portion of the company that they own. Stocks can therefore, at least theoretically, be held indefinitely; the only bond without a maturity date is a perpetuity. Over a long enough period of time, however, and due to inflation induced depreciation, the interest payments on a perpetual bond become close to being worthless.