I am very excited to share my new video with you! I spent a lot of time on this video and I am really happy with how it turned out. Hopefully this helps you understand a little more about how bonds work. This video was slightly adapted from my post a few months ago: What Are Bonds? James Bonds the debt assassin
Here she is! What Are Bonds? James Bonds
Here is a summary of to help you understand how bonds work
Bond Basics –
To understand more about how bond work, you should know that bonds are debt instruments. Not to be confused with stocks, which are equity instruments. Bonds share a few similar characteristics. They have a term: how long the bond will pay interest for. They have a principal amount: the amount paid for the bond. And they have an interest rate: usually paid semi-annually. When the term ends for a bond, the principal is paid back to the investor.
They are used to mutually benefit both an investor and an issuer. The investor benefits from the interest payments of the bond. The issuer benefits from the income raised when the investor purchases the bond.
Many people know that bonds are used as investments to generate income. Their use for financing by issuers is a little less known. Here are a few examples of what bonds are used for from the issuers standpoint to help investors understand them better.
Corporate bonds are used to raise money for corporations. The money raised can vary from company to company, or project to project. Generally, bonds are used for financing operations and projects by corporations. If Goldeneye Co. needs to build a giant laser that costs $5 billion, they will likely need to issue bonds to raise the money to fund the giant laser. Glodeneye Co. will receive their money to fund the laser from bonds, and investors will be paid interest for purchasing those bonds.
Municipal bonds are used to raise money for projects by local governments such as municipalities, cities, towns etc… If James Bond accidentally blew up the Brooklyn Bridge trying to rescue Money Penny New York City would need to rebuild the bridge. If the cost of rebuilding the bridge is $2 billion, New York City doesn’t have an account lying around somewhere with $2 billion in it. So they will issue bonds in order to fund the building of the bridge, and the investors in those bonds will be paid interest for their investment.
In the year 2015, the US spent about $3.55 trillion but they only brought in about $2.99 trillion. This leaves a deficit of about $550 billion. The federal government will issue bonds in order to fund this deficit and keep the government running smoothly. Assuming the UK also runs at a deficit, bonds will help finance government operations, like MI6. That way, James can keep being paid and continue to protect the country.
Investing in Bonds
Now that you understand how bonds work and some reasons behind why bonds exist, you may be wondering about investing in bonds. Let’s go over this very briefly to help you understand how this works.
There are different ways to invest in bonds. You may decide to purchase an individual bond or you may add money to a bond fund. It is important to understand the quality of the bond before investing if you purchase an individual bond, as well as the interest rate, price and duration of the bond.
Bonds are rated by rating agencies such as Moody’s, Standard and Poor’s, and Fitch. These companies each have a unique rating system to help investors understand the risks involved with bonds and bond issuers. If a bond has a high risk of default, the bond will receive a lower rating than if a bond has a low risk of default. If a company has poor financials and will have trouble meeting obligations, you will want to evaluate how high of an interest rate that bond is paying, and the price the bond is selling.
Interest Rate, Price and Duration
Each bond has both a specified interest rate, a price, and a duration. These are two important factors that should be used in conjunction with the credit rating of a bond to understand if a bond is worth purchasing. For example, from our video, Goldeneye Co. may have high risk considering it’s “shady” business dealings. A bond with Goldeneye Co. will have a higher default risk, and with a higher default risk you should desire a high interest rate or a low price for the bond. The $1,000 principal used to sell the bond in our example with a 6% interest rate may not be the best for a bond with a high potential default. To solve this we should understand the term par value.
Par value is an important concept to understand how bonds work. Think of the par value of the bond as the price the bond sold for. In our video, the bond’s principal is the same as the par value. So the par value was $1,000.
If Goldeneye Co. has a lot of risk, you may not want to pay $1,000 for a bond that only pays a 6% interest rate. For example, you may desire to only pay $800 for the bond due to its risk of default. Since the par value is $1,000 and you are only willing to purchase this bond for $800 on the market, the bond is selling at a discount to par.
The opposite is true as well. A bond can be sold at a premium if the bond is sold for an amount higher than its original par value. If Goldeneye’s bond was sold for $1,100, this is more than the $1,000 original par value so it is considered selling at a premium.
Instead of investing in an individual bond, you may decide to invest in a bond fund. You can invest in a bond fund inside a mutual fund company or an index fund. A bond fund is made up of many different bonds purchased by the fund company and managed on behalf of the investors in the fund. A bond fund’s price will fluctuate daily due to the underlying market prices of the bonds a particular fund invests in, or the index a fund tracks.
The majority of investors don’t understand how bonds work, so they don’t typically own individual bonds. Most investors invest in bond funds in order to diversify their portfolios. Bonds tend to have less volatility so they are used by many investors and investment advisors as a way to mitigate the volatility of an investment portfolio.
I hope this helped you to understand a little more about how bonds work. If you are still confused, I hope you were at least entertained by my video!
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This article was updated March 19, 2017
Music by Ian McLeod. Thanks, Ian!
Lounge attribution – Thomas Hawk – https://www.flickr.com/photos/thomashawk/
Bridge – Flickr: Bridge https://flic.kr/p/riooCy
Building demolition: https://flic.kr/p/ogUe7h