What do you know about bonds? Not the bonds between you and your friends, or between Orca and you, that are practically indestructible. And not James Bond actors that you probably didn’t know were nine of them (google it, you’ll see). The bonds we are speaking about are a financial instrument that is often considered one of the safest to invest in. Let’s clarify how a bond works.
Essentially, a bond is a loan paper. “I, the undersigned, confirm that I’ve taken 1,000 pounds from Mr./Mrs. You for a year and I guarantee to pay 1,0000 pounds back at the end of the year with an interest on top” – that, technically, could be classified as a bond.
What’s the difference with a loan? Practically, none: a bond is how companies borrow money from people, that’s it. Technicalities made it a special instrument – here is the story.
The bond story, short
Although banks are the cornerstone of the modern economy, businesses and individuals often prefer giving and taking money from each other instead of them. Why? It’s cheaper. Not always, not everywhere, but quite frequently. For example, company X needs money. It goes to bank Y, and the bank offers a loan of 1,000 pounds for a year with a 7% interest. Company X says “I’m supposed to pay 70 pounds? That’s a bit too much, don’t you think?”. Then, it goes to the public and says “People, give me 1,000 pounds! I’ll give you back the money in a year! Also, I’ll pay you 10 pounds every quarter so you’ll get a total of 40 pounds over twelve months. So, who wants to have 1,040 pounds at the end of the year?”. Company X is happy, the people are happy, and the bank… well, the bank will be just fine.
That’s the essence. Now, let’s rewind this scenario and look at it step by step so that you get the terms of the bond mechanics.
The bond story, walkthrough
You come to company X and ask “So how much did you want to borrow?”, they reply “Just a humble 1,000 pounds”.
The sum they ask for, 1,000 pounds, is a par value, or a bond’s denomination – how much the company borrows.
Face value/principal debt
You agree, take 1,000 pounds from your wallet feeling your eyes wet, hand it over to them, and they give you the bond in return. You take the bond and check it thoroughly – it states “1,000 pounds”. You feel consoled.
What you see – the same 1,000 pounds – is the face value. Because it’s written on the face. Not your face – the bond’s face.
Then you lift your eyes back to the company X representative and ask “Oh, and what’s my interest? I’m not giving you my money for free, you know…”. The person understandingly smiles at you and says “We’ll pay you 40 pounds over a year – that makes a 4% interest on our 1,000-pound bond”.
Here, this 4% is the bond’s coupon. Note that it may be distributed in several payments across the year – from monthly to once in a year.
Just for your understanding: previously, bonds used to be issued in paper form – in those times when there was no Internet, no computer, everything was touchable… And so every time the interest rate to a bond was paid, a physical part of the paper bond was torn off – that part was a coupon. Something like an ad stuck to the wall of a telephone booth with a number on each “coupon” to tear away in case you prefer not to rip the entire ad off. Now, obviously, most bonds are issued electronically, so there are no more paper parts to tear off the bond (what a shame, right?). So, in our day and age, a coupon rate is a more precise term to use.
Before leaving the office of company X, you decide to clarify: “Can you please confirm when exactly I will get my 1,000 pounds back?”. The person says “Precisely in twelve months. It will be January 15th. My birthday, by the way”.
Of course, the person just made it up about the birthday but January 15th would the maturity date – that’s when the bond’s life ends, and it’s time for you to get your money back. On this day, if you had a bond in your portfolio, you will see the principal debt and the last interest payment land into your account while the bond itself disappears. End of the story.
A small correction
Now, there are a lot of different companies issuing a lot of different bonds with a lot of different periods. One-year, five-year, ten-year and other bonds are available to invest in the market. People trade them, buy and sell. They wouldn’t do that if there was no bargain around the price: a bond gets bought and sold at market price which revolves around the par value/face value (see Bond Story, part 2) but is not exactly equal to it. You may ask, “If the bond’s market price is just slightly different from its par value, what’s the reason to trade it?”. The reason is that if an investor trades a thousand bonds squeezing a penny of profit out of the difference between the face value and the market value, it would be a good total at the end of the day. A lot of small profits add up into one good gain shining at you from the screen – that’s the logic and the approach practiced by many bond investors. Also, if a bond is promised to mature in ten years, no one really knows what will happen in ten years, right? Hence, the price… So a bond is an instrument with which you choose safety over risk. Nicely done.