Bonds: Lending to Companies and Governments

What this means

Write on a piece of paper: "I owe you 1,000 dollars, which I will repay in ten years. Every year until then I will pay you 40 dollars." Sign it. You have written a bond.

A bondA tradable debt security in which the issuer borrows a sum and promises to pay interest and repay the principal at a stated date. is a loan turned into a document that can be bought and sold. Companies issue them to fund factories, acquisitions, or equipment. Governments issue them to fund budgets and infrastructure. The buyer of a bond is not an owner of anything; the buyer is a lender, and the issuer owes them money.

The document states its terms up front. The principalThe amount the issuer repays at maturity, also called par or face value. is what gets repaid at the end. The coupon rateThe stated annual interest payment on a bond, usually expressed as a percentage of face value. is the interest the issuer must pay along the way. The maturity dateThe date on which the issuer repays the principal and the bond ends. is when the loan ends. In the IOU above, the principal is 1,000 dollars, the coupon rate is 4 percent, and the maturity is ten years. That is a complete bond.

The critical contrast is with stock. Buying stock makes you a part owner with a claim on profits, and if the firm does poorly you may receive nothing at all, legitimately. Buying a bond makes you a creditor with a contractual claim. The issuer owes you the coupon whether or not it had a good year, and if it fails to pay, that is defaultFailure to make a required interest or principal payment on a debt., which has legal consequences. Bondholders also get paid before shareholders if a company is liquidated. Lower risk, and correspondingly a lower expected return.

Now the two markets, which the standard makes a point of. In the primary marketThe market in which newly issued securities are sold by the issuer, so the issuer receives the funds., an investor buys a newly issued bond directly from the issuer, and the issuer receives the money. This is the transaction that actually finances the factory or the bridge. In the secondary marketThe market in which previously issued securities are traded between investors, with no funds going to the issuer., an existing bondholder who wants their money back before maturity sells the bond to another investor. The issuer receives nothing from that trade and simply pays coupons to whoever holds the bond now.

The secondary market is not a sideshow. Almost nobody would lend for thirty years if the only way to get the money back were to wait thirty years. The ability to sell is what makes long-term lending tolerable, so the existence of the secondary market lowers the interest rate issuers must offer in the primary market. One further consequence: because bonds trade, their prices move. If prevailing interest rates rise after you buy, a bond paying the old lower coupon becomes less attractive, so its price falls. Bond prices and market interest rates move in opposite directions.

Why do bondholders demand interest at all? Three reasons, and they are the same three that underlie every interest rate. Opportunity cost, because funds committed to this bond cannot be used elsewhere. Time preference, because people prefer resources now over resources later and must be compensated for waiting. Risk, because the issuer might default, and the greater the chance of that, the higher the rate the issuer must offer to attract lenders at all. That last point explains why a shaky company pays more to borrow than a stable one, and why credit ratingsA firm's assessment of how likely a borrower is to repay, published as a letter grade. exist.

Why it matters

You will own bonds whether or not you ever buy one deliberately. Retirement accounts, pension funds, and the conservative portion of nearly every target-date fund hold them, because a claim that must be paid is exactly what you want as you approach the point of needing the money.

Bonds also explain public finance. When a school district builds a new high school, it usually does not pay cash; it issues bonds, often after a ballot measure, and repays them over decades from tax revenue. Reading that ballot measure correctly means understanding that a yes vote authorizes borrowing with interest, and that the total repaid exceeds the amount raised.

Try it

1. Write an actual IOU by hand for a hypothetical bond: 1,000 dollars principal, a 5 percent coupon, five years to maturity. Sign it as the issuer.
2. Compute the full cash flow. List each year's payment and the final year's payment including principal. Total what the issuer pays out and subtract the 1,000 dollars received. That difference is the cost of borrowing.
3. Label the parties precisely. Who is the borrower? Who is the lender? Who owes an obligation, and what happens if they do not meet it? Write one sentence on what default would mean for each side.
4. Build a comparison table with three columns: corporate bond, government bond, share of stock. Compare on ownership versus lending, whether payments are contractual or discretionary, who gets paid first in a bankruptcy, and relative risk.
5. Trace a primary market purchase. Draw the flow of funds when an investor buys a newly issued bond from a company. Mark where the money goes and what the company does with it.
6. Now trace a secondary market sale. The original bondholder sells to a new investor after three years. Draw that flow and answer explicitly: how much does the issuer receive from this trade, and to whom does it now owe coupons?
7. Explain in writing why the secondary market matters to the issuer even though the issuer receives no money from it. Your answer must connect liquidity to the interest rate the issuer had to offer in the first place.
8. Reason through price movement. Suppose you hold a bond paying a 3 percent coupon and newly issued bonds of the same risk and maturity begin paying 6 percent. If you want to sell yours today, will a buyer pay more or less than face value, and why? State the general rule you have just derived.
9. Justify interest from the lender's side. In a paragraph, explain why bondholders expect to earn interest, using opportunity cost, time preference, and default risk. Include a concrete example for each.
10. Apply the risk logic. Two companies issue ten-year bonds on the same day. One is a large established utility, the other a new firm with an unproven product. Which must offer the higher coupon, and why would an investor ever choose the lower-paying bond?
11. Look up current credit ratings for two well-known companies and record the letter grades and the agency. Explain in one sentence what the rating is trying to communicate to a potential lender.

Check yourself