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Bonds: What are Bonds?

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As we have seen elsewhere in this module, there are two ways for companies to raise money for long-term business investment – they can borrow it and/or they can issue shares.

When businesses borrow money they often do so by issuing what are called bonds. So what are bonds and how do they work?

What are bonds?

Bonds are debt. They are debt because when an investor buys a bond they are effectively loaning the bond’s issuer a sum of money and that issuer is incurring a debt. So the issuer – or seller of the bond - is a borrower and the investor - or buyer of the bond - is a lender.

The price paid for the bond is the money the investor is loaning the issuer. And, like most other loans, when you buy a bond the borrower pays you interest for as long as the loan is outstanding and then – at the end of the agreed period of the loan – pays you the loan back. 

With bonds, the price you pay for the bond - the loan itself - is known as the principal amount, or the face value of the bond. The length of the loan is referred to as its maturity. And the interest paid on the loan by the borrower is called the coupon.

Bonds are also known as fixed income (and sometimes fixed interest) securities.

This is because most bonds pay a regular income to the lender – a rate of interest on the loan. The amount of interest paid and how regularly that interest is paid is specified in the terms under which the bond is issued.

Another reason bonds are known as fixed income securities is that – unlike stocks, which make no guarantees in terms of their returns – a company that issues a bond guarantees to pay you back your principal plus interest.

     

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