What are Bonds?
Companies need funds for many reasons such as expansions into new markets. The trouble with larger organizations and emerging companies is that they need more money than what they can obtain from a bank loan. Effi Enterprises works with companies to secure various means of financing such as venture capital, private equity financing, stocks and bonds or IPO’s. One solution that is offered to raise money for these companies is to issue bonds to the public market. Through offering bonds publically, it means that rather than looking for one huge investor, thousands of investors can lend a small portion of needed capital. A bond is essentially a loan in which the company is the lender. The company which sells a bond is called the issuer. It is sort of like an IOU given to a lender (the investor) by a borrower (the issuer).
There is a little more depth to it than a simple loan because most people do not loan out their money without expecting something in return. This means that the issuer must offer the investor something in exchange for the loan of their money. This comes from interest payments the rate of which is predetermined and they are made according to a schedule. The date which the issuer has to finish paying the borrowed amount is referred to as the maturity date. Bonds are classified as a fixed-income security because the amount that an investor will get in return is fixed as long as the bond is held until it matures.
What is the difference between stocks and bonds?
The difference in bonds and stocks is that bonds are a debt but stocks are equity. An investor can become part owner of a company by purchasing stock, or equity. But when an investor purchases debt, or bonds they become a creditor to the company. There is an advantage of becoming a creditor in that they will have a higher claim on assets than a shareholder will and if there was a failure causing a bankruptcy they would receive their money before the shareholders. The disadvantage is that a bondholder does not own shares of the company and it the company realizes large profits they will still only get their fixed amount in return. This means that owning bonds is less risky than owning stocks but there is also a much lower return.
Why purchase bonds?
It is true that stocks can offer a larger return than bonds, especially for time periods of at least 10 years. But that does not mean that investing in bonds is a bad investment. Bonds can be a good investment if you are unsure of the stock market’s short term volatility.
What types of bonds are available?
There are two basic types of bonds: municipal and corporate. Municipal bonds are also called “munis.” The returns on this type of bond will incur no federal taxes. Oftentimes local governments will also make their bonds tax free for residents which make them a completely tax free investment. These can be a great investment for many individuals. Corporations offer bonds in the say way it issues stocks. Sometimes a corporate bond is as short as a 5 year term, intermediate are 5 to 12 years and long term is anything over 12 years. These have a higher yield, but it also has higher risk involved. They are more likely to default than a government; but they can also be one of the most rewarding of all the fixed income investments. The credit quality of the company is also very important. Companies can also offer convertible bonds which can later be converted to stocks. Or they can offer callable bonds which the company can redeem before maturity.