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What is a Bond? Why is it Important? Classiarius Explains

What is a Bond? Why is it Important? Classiarius Explains

We often hear about bonds and bond markets because it is one of the most often used securities in almost every country around the world. Here you will find a short piece on bonds or fixed income instruments as the market calls them. 

A bond is fixed income instrument that acts as a loan usually to a government but also to a corporation. You can think of a bond as a loan or IOU between the lender and borrower. Think about issuing a bond, the issuer receives the full amount of the bond, but then pays the coupon each month, let`s say, 3 percent in a fixed amount. The buyer of the bond receives fixed cash flow and for this reason, pension funds and life companies tend to like these securities as they know what the fixed amount of cash flow will be this month, next month and until the bond matures. When it matures the transaction is over. The bond buyer is only a lender, so he or she owns no stake in the airport, the highway or any other entity that issued the security.

If a government issues bond you may feel that this is a safe bet, as governments have cash flow from tax payers. If the bond is issued by a corporate, a very weak company, rather than the interest of 3.0%, the bond would be far more attractive at 10%. In short, the safety of the government would mean that the buyers of the bond would be happy to 3.0%. But the excessive risk of a questionable lender, a weak corporate means that the coupon received for that added risk should be 10%.

Have you ever noticed that when massive projects are underway, like the building of a new airport, a tunnel, a bridge, that bonds are used? Most bonds will be set at par, usually $100 or $1,000 face value per individual bond. As we alluded to above, credit quality of the issuer, the length of time until expiration and the interest rate environment are key when calculating the price of the bond.

Let`s say you buy a farm that was abandoned 50 years ago. You issue a $300,000 bond and pay 5% interest the those purchasing the bond. You take that old farm, rework the land with new farm equipment, restock it with animals over a 2 year period. You are ahead of schedule and sell the farm. Those buying the bond have made money, they are rewarded and the farm has been put back on the market and is producing food. Everyone has done well.

Or if an auto company is building a new factory. It can issue a bond. A new airport or highway being built in your city? Yes sometimes bonds make sense. But note that the risk varies depending on the name and credit of the firm or entity issuing.

You read our articles and as you know we have written about Venezuela. Imagine the government of Venezuela trying to issue a bond. Would you buy it at 3.0% ? Or would it need to pay you 25% to get your interest for the added risk ? Think about Japan (safe), Turkey (slight fear, must pay more to buyer) and Venezuela (insane fear, must pay enormous amounts to buyer) issues bonds ? Investors would be rewarded differently for higher levels of risk.

Team Classiarius



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Disclaimer: We do not provide investment advice or strategies, this article is not intended as such but only to provide you the reader with information. Please conduct your own research before any investment of any kind.

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