The stock market may be very intimidating for some people. For most people the money market revolves around just a few things such as cash, checks, and credit cards. But what about the many other instruments you read about in the business section of the newspaper – instruments such as bonds, stock, and options?
It may take some time to get used to these terms so it’s best to tackle them one by one. For now, let us focus on bonds.
Bonds are certificates sold by corporations and governments to raise money for their capital. Those who purchase these bonds are essentially loaning money to the bond's issuer in return for interest. The investor can hold the bond and collect interest payments or sell the bond to a third party.
The first bonds were issued by the Dutch East India Company in 1623.
Bonds are usually held by the buyer longer than a set minimum period. This period is called a maturity period. The buyer must hold the bond for this period to earn the interest for that bond.
Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (part ownership of a company due to ownership of stocks is called equity), whereas bond holders are in essence lenders to the issuer.
A bond's principal, or face value, represents the amount of the original loan that is to be repaid on the bond's maturity date. The interest that the issuer agrees to pay each year is known as the coupon. This term comes from the fact that during the olden times people would attach coupons that could be redeemed as interest payments at the bottom of bond certificates.
There are many kinds of bonds: zero-coupon, floating-rate, callable, putable, and convertible.
Zero Coupon Bonds
These bonds do not make periodic interest payments. The buyer only makes a profit by buying the bond below its principal, or face value
Floating Rate Bonds
The coupon rate or interest rate for this kind of bond varies according to an established formula. The maturity date for this kind of bond can also be changed according to pre-set agreements.
Callable and Putable Bonds
The Callable type of bond allows the issuer to pay off the interest prior to the maturity date, while the Putable bond allows the buyer to force the issuer to pay the interest before its maturity date.
This bond allows the bondholder to exchange the bond for shares in the issuer’s common stock at a specified date.
Bond issuers can sell bonds through an auction process or through investment banking services. The investment banker can then buy the bonds from the issuer and sell them to the public.
Stocks offer a higher potential return if share prices rise. Bonds, however, are generally a safer investment. Stock dividends depend on company profits. Bond interest payments, on the other hand, are made even if the company is losing money. If a corporation goes bankrupt, bondholders are paid before stockholders.
Investing in bonds, though, has its risks, too. Because most bonds offer fixed rate interest, a bond with a low interest rate will be less valuable if interest rates rise to the point that the investor's money could be better off invested elsewhere. If the inflation rate rises in relation to the coupon rate, the value of the investor's return will be reduced.
Bonds are said to be safer that shares due to the fact that their interest rate and face value are stable. Prices for shares may fluctuate wildly leading some cautious investors to invest in bonds instead.
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James Monahan is the owner and Senior Editor of
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