Bonds: lending money for interest

A bond is a loan you make to a company or government

You've seen that a stock is a piece of ownership. Bonds work the other way. What is a bond, really? A bond is a loan you make to a company or a government. In return, they pay you interest. Interest is what a borrower pays for using your money.

Picture your friend Sam. His car broke down, and he needs 1,000 dollars to fix it. You lend it to him. Sam promises to pay you 50 dollars every year for using it. In five years, he gives you the 1,000 dollars back.

A bond is the same deal, written down. The issuer is the company or government that borrows. The bondholder is the investor who lends. Companies issue bonds. So do cities, states and the federal government. Each one is borrowing money from investors.

Being a lender has a perk. If a company fails, its bondholders are paid before its stockholders. Here's where people slip. They think a bondholder owns part of the company. A bondholder owns the loan, gets no vote, and gets no share of profits.

Keep this one idea. A bond is a loan to a company or a government, and it pays you interest.

Par, maturity and coupon: the promise in a bond

A bond is a loan to a company or a government. Every bond makes a promise, and that promise has three numbers. What do they mean? The first number is par. Par value is the amount the issuer pays back at the end of the loan. On the exam, par is 1,000 dollars per bond unless the question says otherwise.

The second is maturity. Maturity is the date the loan ends and the issuer pays back par. The third is the coupon. The coupon is the yearly interest, written as a percent of par.

Say a bond has a 5 percent coupon. It pays 5 percent of 1,000 dollars, which is 50 dollars every year. Most bonds split that into two payments, six months apart. You'd get 25 dollars each time, 50 dollars a year.

The common slip is the decimal. People get 5 dollars or 500 dollars. Write 5 percent as 0.05, and multiply by 1,000. Par comes back at maturity. The coupon is the yearly interest, as a percent of par.

Worked example: yearly interest on 10 bonds

1. A customer owns 10 bonds. Each has a 4 percent coupon and a 1,000 dollar par. How much interest does she get each year?
2. Start with the meaning. The coupon is the yearly interest, as a percent of par. So we'll find one bond first.
3. Write 4 percent as 0.04. Then 0.04 times 1,000 dollars is 40 dollars a year for one bond.
4. She owns 10 of them, so multiply. 40 dollars times 10 bonds is 400 dollars a year.
5. Most bonds pay twice a year, so she'd get 200 dollars every six months. The yearly total is still 400 dollars.
6. Find the interest on one bond, then multiply by how many bonds there are.

Common mistakes

A bondholder is a lender, not an owner

You treated a bondholder like an owner. A bondholder lent the issuer money. Lenders get interest, then their par back at maturity. Votes and a share of the profits belong to stockholders. With stock, you own the company. With a bond, you lend to it.

Move the decimal two places for the coupon

The decimal slipped. Turn the coupon percent into a decimal first. 6 percent is 0.06. Then 0.06 times 1,000 dollars is 60 dollars a year. Quick check: 1 percent of par is 10 dollars. So 6 percent has to be 60 dollars.