What Are Bonds And How Do They Work?

Bonds are loans made to different organizations – corporations, cities, and the government. When a company issues a bond to an individual, the money it receives is a loan. The company must therefore repay the borrowed money over time.  Like credit cards or mortgages, the repayment has added interest to be paid to the lenders.

For instance, if I buy a government savings bond, I become a lender to the government. The government is indebted to me. So, if I put $1,000 in a government bond with a 10% interest rate over 30 years, the government will pay me 10% of my money ($100), every year for 30 year – that’s $3000. In addition, the government gives me back the original amount I put in. Interest rates are determined based on a lot of factors, which include current market interest rates.

Prices of bonds vary with the type of bond and its issuer. With as little as $100, you can buy U.S. Treasury securities direct from the Treasury. U.S. Treasury securities, which are issued by the U.S. Department of Treasury on behalf of the federal government, and corporate bonds by private and public corporations, both trade in $1,000 denominations. Municipal bonds, which are issued by states, cities, counties, and other government entities, trade in $5,000 denominations. A U.S. Treasury zero-coupon can be purchased for less than $1,000.

But How Did Bonds Come About?

Bonds Poster

An Old Poster About Bonds in Times of War

The first bond recorded was a stone discovered in Mesopotamia (now Iraq) dating back to 2400 B.C., when the currency of the time period was Corn. This stone was said to have guaranteed the payment of grain by the principal, and the surety bond guaranteed reimbursement if the principal fails to make payment.

In Venice, around the 1100s, government bonds were issued to fund wars. The bond market continued to evolve in the 14th century, when Venetians could purchase and trade government security, which paid the owner a yearly fixed sum of money FOR LIFE.

Meanwhile, in the United States, the first government bond was issued to raise money for World War I. People would buy these bonds from the government; pay fixed rates in a loan format, and then have the government repay it after the maturity of the bond. The sale of war bonds, known as “Liberty Bonds” afforded the United States government $21 billion dollars of debt which was repaid following the war.

Today, the purpose of bonds has vastly grown. They are not only used to fund wars, but for the building of schools, roads, or public infrastructures. In the same way, corporations make use of bonds to purchase land, equipments, properties, and whatever they may need for their business. Governments and large corporations are the most common entities that issue bonds, because the money they need are much larger amounts than the banks can provide.

Why Do People Buy Bonds?

Bonds give small investors a way to earn a profit on their money from the interests paid, which is typically twice a year, so bonds provide a predictable income stream. Also, if the bonds are held to maturity, bondholders get back the entire amount they put in. In a way, bonds preserve the capital you put in while investing.

However, bonds also are also subject to several risks which include call and prepayment risk, credit risk, and reinvestment risk, among others.

If a company goes bankrupt, its bondholders have no guarantee in regard to the amount of money that’s returned to them, as it only depends on the proceeds of the sale of assets ahead of some other creditors. Some bonds are also callable, which means that even if the company agreed to make payments plus interest for a period of time, the company can choose to pay it off early. This forces the bondholder to find a new place for his money. It’s especially harder, because companies usually pay off bonds early when interest rates fall.

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