A bond is a debt: the issuer of a bond (a company, government, or other entity) borrows money from the purchaser of a bond (bond holder). Until the bond matures (the debt becomes due), the issuer will make periodic interest payments to the bond holder. On the maturity date of the bond, the issuer pays back the principal (the amount borrowed) to the bond holder, and possibly also makes a final interest payment.
From the point of view of the issuer, bonds may be an attractive alternative to borrowing from a bank (perhaps to avoid restrictive loan terms or to obtain a better interest rate), or to issuing stock (which would dilute the equity or ownership stake of the current owners of a company). From the point of view of the bond holder, bonds may be attractive relative to other investment alternatives, perhaps paying better interest rates than bank deposits or being more certain of retaining their value than stocks. With some exceptions, bonds are freely traded, so that the bond holders are not locked into their investments. (All of these advantages are possibilities and not certainties, as discussed below.)
As an illustration, suppose a company wants to build a factory which will cost US $1,000,000. The company may issue a bond to cover this amount. The bond could either be backed by the factory, or could be a debenture, which is only a call on the future income of the company. The face value of the bond would be $1,000,000, which typically would be sold in increments of $1,000. (The face value of the bond is distinct from the current price in the marketplace, which might be more or less than the face value.) The bond might pay an interest rate of 5% (also known as having a 5% coupon), typically in semiannual payments of 2.5% each, and could have a maturity of up to 30 years. For example, assuming the 5% and 30 year figures above, the bond typically would make 60 payments of $25 per $1000 of face value, with a final repayment of the principal coinciding with the last interest payment.
The purchase price of a bond is often not the price found on the bond itself, but can vary based on the interest rate of the bond, as well as the accrued interest on the bond. An increase in interest rates results in lower bond prices, and a decrease in interest rates results in higher bond prices (this is known as a loss or premium over the face value of the bond).
Bonds return around 5% a year on average. To have a higher return in bonds you invest in riskier bonds. They are known as junk bonds. Bonds have a credit rating which shows their risk rating. The credit ratings go from AAA, AA or A, BBB, BB B, CCC, CC, C, DDD, DD, D. AAA bonds are seen at a very low risk of default. BBB indicate some problems. CCC bonds can be viewed with caution. DDD are bonds at a high risk of default.
When can you use bonds? You could use bonds if you are an investor who would not want stocks and shares prices ups and down. How do you invest in bonds. You can invest in bonds through funds. You can also invest in bonds through stockbrokers. Be careful of too high charges on a bond fund, it could take away from the potential profits.