What is a bond? Everyone has heard of bonds, but do you know what a bond is? Most people have some vague idea, but when pressed, can’t exactly explain what they are or how they work. The bond market is far larger than the stock market and you absolutely must understand it to comprehend the changes that occur in an economy and in order to protect your wealth. We’ve spoken about Treasury bonds before, but want to give you a more rounded understanding today.
You see, most people have the idea that a bond is always safe. That could be a disastrous assumption. But bonds are guaranteed. What? That’s right, let’s figure out exactly what a bond is…
A bond is a debt instrument. When you buy one, you are essentially lending money to a company or government in return for a promise that they will pay you back your principle with interest. So yes, a bond is guaranteed by the entity which is issuing it. So your interest payments and principal will be paid to you exactly as promised unless the entity itself has financial problems and can’t make the payment. In this case, you have a claim against the entity as the lender (although this really only does any good against a company).
To assess the credit worthiness of the entity you are lending money to, you can study their financials as well as looking into the rating assigned by the ratings agencies. These Ratings can be as high as AAA and as low as C or D depending on the rating company. You can see a chart of ratings at http://en.wikipedia.org/wiki/Bond_credit_rating. However, don’t take these ratings too seriously. Remember, these agencies had Enron rated AAA before it went bankrupt. Bonds rated BBB (Baa) or better are typically referred to as “Investment Grade” bonds while those with lower ratings are called “High Yield” or “Junk” bonds.
A bond has a certain maturity at issue. Typically, they have a set dividend payment schedule (although there are zero coupon bonds which pay no dividends and all interest is earned at maturity.) Many bonds pay this dividend twice a year.
For example, if you bought $10,000 of 30 year bonds at 5% from McDonald’s, they would pay you $250 (2.5%) every 6 months for the next 30 years and then at the end, return your $10,000 to them.
In practical terms, most bonds that you might buy are bought on the secondary market. This means that you would buy the bond from someone else (who bought it from someone else) who originally lent the money to McDonald’s. But as the holder and owner of the bond, you are the one to now receive the interest and return of principal.
So a bond is guaranteed, but what are the risks? That’s what we’ll look at next…