What is a bond?

In finance, a bond is a debt investment in which the issuer (debtor) borrows funds for a defined period of time from the lender (creditor) at an interest rate that can be variable or fixed. It is a debt security, typically corporate or governmental).

Interest is usually payable at fixed intervals (monthly, semi-annual, annual). Usually, bonds are tradable; therefore the ownership of the instrument can be transferred in the secondary market. Once the transfer agents at the bank medallion-stamp the bond, it is highly volatile on the second market.

Some corporate bonds are callable, if the company can call them back when the interest rates drop enough. Others are putable, when the creditors can put them back to the issuer if the interest rates increase.

A bond is commonly known as an IOU (I Owe You), and is used to provide the borrower with extra funds to finance long-term investments. Governmental bonds allow financing current expenditure.

Bonds vs Stocks

The main difference between bonds and stocks is that stockholders have an equity stake in the company, as they purchase a share of the ownership, whereas bondholders have a creditor stake in the company. Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors in the event of bankruptcy.

Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks are typically outstanding indefinitely. An exception is an irredeemable bond which is a bond with no maturity.

Types of bonds

There are three main types of bonds:

Governmental bonds, also known as municipal bonds. In some cases, these bonds can be offered as a tax-free income coupon for locals.

Corporate bonds, when the issuer is a private company.

US Treasury bonds, bills and notes issued by the US government. They are commonly called “Treasuries”.

Zero-coupon bonds, or accrual bonds, do not pay out regular coupon payments but are issued at a steep discount.

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Category: Financial Glossary

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