How Does a Bond Work?

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Businesses and public agencies don't always have enough cash on hand to fund future ventures. Bonds can be a way for both to raise cash. When you buy a bond, you're essentially making a loan to the issuer. The issuer promises to pay you back when the bond matures and will also make interest payments -- known as coupon payments -- over the life of the bond.

Bond Components

The face value of the bond is what the bond will be worth at maturity -- in other words, it's the amount that the issuer will pay you back when the bond matures. Sometimes, the face value of the bond is also the issue price -- the price you pay for the bond. If this is the case, investors say that the bond is issued at par.

In other situations, the issue price may be more or less than the face value. The price you pay depends on the rate of interest attached to the bond. If the bond pays the current market rate of interest, you'll purchase it at par. However, if the agency pays you a higher rate of interest, you'll pay more for the bond upfront. If the rate of interest is lower than average -- or you don't receive interest payments at all -- you'll pay less for the bond upfront. When you pay more than the face value, the bond is issued at a premium. When you pay less, it's issued at a discount.

Buying and Selling Bonds

You can buy a bond directly from the corporation, bond underwriter or public agency selling the bond. You also can buy and sell bonds on a bond market. Along with trading stocks, you can buy and sell bonds on major exchanges like the NASDAQ and the New York Stock Exchange. If you sell a bond, all subsequent coupon payments will be made to the new owner, and she'll receive the maturity payment. Conversely, if you a buy a bond midway through it's life , all subsequent coupon payments will be made to you, and you'll receive the maturity payout.

Rate of Return and Bond Risk

Compared to stock, bonds typically are less risky investments. That's because debt has a higher priority when it comes to claims on a corporation's assets. In other words, if a corporation becomes insolvent, it has to finish paying back its bonds before any money is distributed to stockholders. Certain other forms of debt rank higher than bonds, so you're not necessarily guaranteed to be paid back.

Because bonds are less risky than stocks, they tend to offer a lower rate of return. If you look at historic data, you can see that the average rate of return on bonds historically is significantly lower than it is for stock. However, it also has a lower standard deviation -- in other words, you're less likely to have a loss after buying a bond.

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