Bond

Definition

A bond is a financial asset that represents a loan made by an investor to a borrower, typically a corporation or government. The bond issuer promises to pay back the principal amount on a specified maturity date, along with periodic interest payments, known as coupon payments. Bonds are crucial in the financial market as they provide a way for entities to raise capital while offering investors a relatively stable return on their investment.

5 Must Know Facts For Your Next Test

1. Bonds are generally considered less risky than stocks, making them popular among conservative investors looking for steady income.
2. The creditworthiness of the bond issuer impacts the bond's interest rate; higher-risk borrowers must offer higher yields to attract investors.
3. Bonds can be traded on secondary markets, which can affect their price based on changes in interest rates and market conditions.
4. Government bonds are often seen as a safe investment, whereas corporate bonds may carry more risk depending on the financial health of the issuing company.
5. Inflation can erode the purchasing power of the fixed interest payments received from bonds, which is a critical factor for investors to consider.

Review Questions

• How do bonds function as a financial asset and what are the benefits they offer to investors?
  • Bonds function as loans from investors to issuers, providing capital for corporations and governments while promising to repay the principal plus interest over time. They offer benefits such as predictable income through coupon payments and reduced risk compared to equities. Investors often turn to bonds for portfolio diversification and stability, especially in volatile markets.
• Analyze how changes in interest rates affect the value of bonds in the financial market.
  • When interest rates rise, existing bonds with lower rates become less attractive, leading their prices to drop in the secondary market. Conversely, when interest rates fall, existing bonds with higher rates increase in value. This inverse relationship is critical for investors as it impacts their decisions regarding buying or selling bonds based on current economic conditions.
• Evaluate the role of government bonds versus corporate bonds in an investment portfolio and how they respond to economic fluctuations.
  • Government bonds are generally seen as safer investments, offering stability and low risk, which makes them appealing during economic uncertainty. In contrast, corporate bonds carry more risk but typically offer higher yields, attracting investors during periods of economic growth. Evaluating these roles helps investors balance risk and return based on their financial goals and market conditions.

Related terms

Coupon Rate: The interest rate that the bond issuer pays to the bondholder, usually expressed as a percentage of the bond's face value.

Maturity Date: The date on which the bond's principal amount is due to be paid back to the bondholder.

Yield to Maturity: The total return expected on a bond if it is held until maturity, taking into account both the interest payments and any gain or loss if the bond was purchased at a price different from its face value.