What exactly is…a bond?

Introduction

A bond, as opposed to a stock, is not a piece of the company, but rather a certificate of indebtedness. If you buy a bond with a company or the government, you lend it your money – that is, you give it a loan.

Let’s take a step back and practice some role reversal:

When you take out a loan with your bank, you get money…clear. You then pay the money – plus interest on top – back to your bank over a period specified in the loan agreement. The interest payment is compensation, so to speak, for the bank loaning you money when you needed it but didn’t have it. A bond is exactly the same thing, just flipped on its head, from your perspective as an investor. Because you indeed have money, which you want to invest. And the company or the government agency that needs money can borrow that in the form of a bond. From you, for example. :)

To do that, the company issues a bond, which you can buy. You then get a piece of paper, figuratively speaking, that says on it that you have loaned money to that company or to the government and that you’ll get it back at the end of the predetermined time period. Plus interest! The interest varies in amount and depends on things like current policy rates in the economy and the risk you’re assuming as an investor in loaning your money.

That is, if it’s fairly likely that whoever you’re lending money to (government agency or company) will go bankrupt, you can charge a higher interest rate as a risk premium. If bankruptcy is next to impossible, you’re just going to get a very low interest rate – after all, there are many other people who would be glad to loan money to that company or government agency. The good thing about bonds is that after a certain period of time, you get the money you invested back and something on top of it after interest. The investment is easily calculable at the outset.

If you buy bonds from issuers (that’s what companies and governments that issue bonds are called) that are considered very reliable, it’s a preeetty low-risk investment. An example close to home: the German government! It has the reputation of being a total safe haven, and it’s very unlikely to ever go bankrupt. That’s exactly why it’s been issuing bonds with negative interest for some time. That means that at the end of the time period, you get less money than what the bond cost. Sound silly? It is in a way, but there’s a reason: Right now, bonds from the German government are a secure parking lot for your money. And this security is worth the loss for many people on the financial market.

The profit you can gain from a bond is made up of two parts:

The coupon is the nominal interest rate of a bond. If you loan 100 euros with a coupon of 5%, you get five euros a year in interest.

The price gain is not determined by the paper, but rather by the market. Just like stocks, bonds are also traded on the financial markets. If you buy a corporate bond from company X that goes for 10 years (i.e., you loan company X a certain amount of money right now for 10 years), you don’t necessarily have to keep it yourself for 10 years. You can sell it to anyone else on the financial market, assuming you come to an agreement on the price. If the other party is prepared to pay you a high price, you turn a profit.

Many factors influence this price, such as the current economic environment, a potential special situation for the company or government agency whose bond you’re trying to sell, future outlook and expectations, and…and…and…. At any rate, the many players on the financial market never seem to all come to an agreement on this anyway. :) What’s important for you to know is that you probably won’t get the exact amount that you paid for the bond. Maybe you get a little more, maybe a little less. Remember that, although it only applies if you want to sell the bond prematurely.