What is a Bond?

Before we discuss bond investing, we need to answer the question 'what is a bond'. In later sections, we will answer 'what is a savings bond' and 'what is bond market'?

What is a bond?

Before we defined what a bond is, let's examine the following scenario. If you need to raise money or capital for your new business, what would you do? You probably will obtain a loan from someone or a bank. To borrow any money, you need to give the lender some incentives such as interests. This same concept is used on a larger scale by companies and governments.

When a company or a government entity needs money to fund their businesses, they can also borrow from financial institutions or banks. The financial institutions then break up the loan into small chunks of $1000 each. They then sell these chunks of loan to investors. These chunks are called bonds. Investors are the lenders who are promised interests from the borrower.

Common bond terms

The principal is the original amount borrowed. The principal of the bond is the money you lend the bank or the company issuing the bond. In return, they will pay you back, not the principal but the, par or face value of the bond at maturity (see below).

The maturity is the date in the future at which the bond matures. At this date, you are repaid the principal plus any interests not yet paid. Most bonds pay interests regularly every six months.

The face or par value of a bond is the $1000 in the above example. Every bond is issued with a face value. The face value is not necessarily the price of the bond when you purchase it. Sometimes, the bond is sold at a discount and you pay less than the par value for the bond. Other times, the price of the bond is higher than the par value. It doesn't matter how much you pay for the bond, at maturity, you will not get this amount back. You will get the face or pay value of the bond back instead.

Investing in the bond market

When investing in the bond market, you need to particularly watch out for interest rates and inflation, more so than stocks. When interest rates rise, a bond's value falls. That means the higher the interest rates, the less valuable the bond is.