How to Define a Bond as a Financial Tool - dummies

How to Define a Bond as a Financial Tool

When a government or business — think the United States government, or the city of Philadelphia, or Procter and Gamble — needs to raise money, they may decide to issue a bond. A bond is really not much more than an IOU with a serial number. More impressive names for bond include debt securities or fixed-income securities.

A bond is always issued with a certain face amount, also called the principal, also called the par value of the bond. Most often, simply because it is convention, bonds are issued with face amounts of $1,000. So in order to raise $50 million, they would have to issue 50,000 bonds each selling at $1,000 par. Of course, they would then have to go out and find investors.

Every bond pays a certain rate of interest, and typically (but not always) that rate is fixed over the life of the bond (hence fixed-income securities). The life of the bond, in the parlance of financial people, is known as the bond’s maturity. The rate of interest is a percentage of the face amount and is typically (again, simply because of convention) paid out twice a year.

So if a corporation or government issues a $1,000 bond, paying 6 percent, that corporation or government promises to fork over to the bondholder $60 a year — or, in most cases, $30 twice a year. Then, when the bond matures, the corporation or government gives the bondholder his or her $1,000 back.

In some cases, you can buy a bond directly from the issuer and sell it back directly to the issuer, but in most cases, bonds are bought and sold through a brokerage house or a bank. These brokerage houses take a piece of the pie, sometimes a quite sizeable piece.