What is a Bond? Ask The Professor: In this episode of Ask The Professor, Professor Milligan discusses bonds, including treasury bonds, corporate bonds, municipal bonds, yields, safety and tax ramifications.
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). It’s a form of debt investment in which an investor loans money to an entity (corporate or governmental) which borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.
The main features of bonds include:
- Principal (Face Value): The amount that will be paid back to the bondholder at the maturity date, which is when the bond’s term has ended. This is also the amount on which interest payments, or coupons, are calculated.
- Coupon Rate: The interest rate that the bond issuer will pay on the face value of the bond, expressed as a percentage. This can be fixed or variable.
- Maturity Date: The date on which the bond will mature, and the issuer will pay the bondholder the face value of the bond. Bonds can have short, medium, or long terms (e.g., one year, five years, ten years, or even thirty years).
- Issuer: The entity that issues the bond and borrows the funds. Issuers can be corporations, municipalities, or governments.
Bonds are considered a relatively safe investment compared to stocks, but they do carry risk, including interest rate risk, credit/default risk, and inflation risk. The price of bonds in the secondary market can fluctuate based on changes in interest rates and the credit quality of the issuer. When interest rates rise, bond prices typically fall, and vice versa.
Investors in bonds receive regular interest payments on the coupon rate until the bond matures, at which point they are repaid the bond’s face value. The regular income and return of principal at maturity make bonds an attractive investment for those seeking steady income or to preserve capital.
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