Bond – Definition
A bond is a debt instrument through which an investor lends money to a company, government, or other organization for a fixed period at a predetermined rate of interest. In return, the borrower agrees to pay regular interest and repay the principal amount on maturity. Bonds are commonly used by companies, municipalities, states, and national governments to raise funds for various projects and activities. They are known as fixed-income securities and are considered one of the three major asset classes, along with shares and cash equivalents.
What is a Bond?
A bond is a long-term debt instrument issued by governments, companies, or other institutions to raise capital through borrowing. It is generally issued for a period of more than one year. When an investor buys a bond, they lend money to the issuer and become a creditor, not an owner as in the case of shares.
The issuer promises to repay the principal amount on a fixed future date called maturity, along with regular interest payments known as coupons. Some bonds may not pay periodic interest, but all bonds require repayment of the principal amount at maturity.
Bondholders have a stronger claim on the issuer’s income and assets than shareholders in case of financial difficulty. Bonds can be classified in different ways, such as by issuer type, maturity period, credit quality, tax status, and whether they are secured or unsecured.
The return from a bond may come from:
- Coupon interest (regular interest payments)
- Capital gains (if sold above purchase price)
- Interest on interest (reinvestment of earnings)
A bond may be sold at par value, above par (premium), or below par (discount), but its market value generally moves closer to par as maturity approaches. Usually, higher-risk bonds offer higher returns. Some bonds, especially those issued by local or state governments, may also be tax-exempt.
Types of Bonds
1. U.S. Treasury Bonds
These are debt instruments issued directly by the U.S. government. The government uses the funds raised through these bonds to meet public expenditure, finance projects, and repay existing debt. They are considered among the safest investments because they are backed by the government.
2. Agency Bonds
These are debt securities issued by agencies of the U.S. federal government or by government-sponsored enterprises (GSEs). The funds raised are generally used to support public policies and specific sectors of the economy.
3. Municipal Bonds
These bonds are issued by states, cities, counties, and other public authorities. The money raised is used to finance public projects such as schools, hospitals, highways, drainage systems, and universities. In many cases, the interest earned may be tax-exempt.
4. Corporate Bonds
These are bonds issued by companies and corporations to raise capital. Businesses use the funds for expansion, capital improvements, refinancing existing debt, or acquisitions. Corporate bonds usually offer higher returns than government bonds but involve greater risk.
5. High-Yield Bonds
These are bonds with credit ratings below investment grade. Because the issuing organizations have a comparatively weaker ability to repay interest and principal, they offer a higher rate of return to attract investors in exchange for the additional risk involved.
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