What Is a Bond?
Most people have questions about equity and stock, but what about bonds?
Bonds are very important—they are a lifeblood to the global economy.
The official definition of a bond is a debt instrument issued by governments, corporations, and other entities to finance projects or various activities. It’s a mouthful, but it’s the technical definition.
To get a better understanding of what a bond is, we can break it down a little bit further.
Imagine you’re a corporation or a government, and you need money to do stuff.
Governments might want to build bridges or airports or fund education or hospitals. A corporation might want to expand; they might want to build a factory or start a new research and development project. To do that, it takes money. You don’t need money later; you need it now. It’s the same for both corporations and a government.
So, they raise money by issuing bonds—by issuing debt.
A bond is a promise to pay. It is an agreement with legal force.
It’s helpful to remember the verb definition of a bond, which is to join or be joined securely to something.
Here’s an example.
The government issues a bond, and you, as an individual, decide to pay for the bond. The government takes the money that you’ve just given them and invests in that airport or hospital. But the government will pay you back, and it will pay you back with interest.
Say you put $100 into this bond investment—you gave the government $100. For ease of calculation, we say there’s an interest on that of 10%. So, after one year, you get back your principal of the $100 you invested originally, plus you get $10 of interest; that’s the 10% calculated annually.
Now, imagine if it was higher interest rates for longer periods of time, and you’ve got the security of the government to pay you back. Sounds great, doesn’t it?
It’s a good way of raising money for the government, and it’s a good way for the rest of the population to earn some money on their cash.
Now, as we discussed before on interest rates, if you’re going to lend, you’re going to want to charge interest for that lending. In this example we just used, we said 10%. But how do we come up with that number?
How is the interest rate of bonds calculated?
It comes from two factors: the risk-free rate and the risky rate.
The risky rate is the probability that you will get your money back. In other words, what is the probability that the entity that you lend it to will default and be unable to pay back the loan? For a government, it’s not likely, so the risky rate is going to be very small.
For some countries, it has happened, so it’s not unheard of.
For corporations, the risky rate is much higher. The average life expectancy of a stock or a company on any one of the major exchanges has dropped from 61 years to 18 years. So, the possibility that a company may default on the loan is something to consider.
But even with the possibility of a company defaulting, bonds are still an excellent stream of steady income. They are low risk.
Even if a corporation were to go bankrupt, the bondholders get paid first out of what is left of the company. When the liquidators come in, they sell all the assets—computers, cars—hardware, the building, etc. The equity holders (the people that hold the stock) get nothing, but the bondholders get paid first.
Bonds are a great investment; they should be part of everyone’s portfolio. I highly recommend people think about investing in bonds as part of a diversified investment plan.
When thinking about bonds, remember…
- Bonds are integral to the global economy—they will be around for a long time.
- Bonds are a win-win for companies and the public.
- The risk for government bonds is very small—making them a great investment.
- If a company goes bankrupt, bondholders get paid first—holding bonds is safer than holding stock.
- Bonds make a great addition to a diversified investment plan.
Do you want help investing in bonds? Talk to the Wall Street Guy team today.
This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
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Who is Paul Atherton, That Wall Street Guy?
An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.
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