A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.
Bonds are commonly referred to as fixed-income securities and are one of the three main generic asset classes, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded on exchanges, while others are traded only over-the-counter (OTC).
How Bonds Work
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate (coupon) that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date).
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The terms on which a government can sell bonds depend on how creditworthy the market considers it to be. International credit rating agencies will provide ratings for the bonds, but market participants will make up their own minds about this.
The first general government bonds were issued in the Netherlands in 1517. Because the Netherlands did not exist at that time, the bonds issued by the city of Amsterdam are considered their predecessor which later merged into Netherlands government bonds. The average interest rate at that time fluctuated around 20%.
The first ever bond issued by a national government was issued by the Bank of England in 1694 to raise money to fund a war against France. It was in the form of a tontine. The Bank of England and government bonds were introduced in England by William III of England also called William of Orange who copied the 7 Dutch Provinces approach of issuing bonds and raising government debt where he ruled as a Stadtholder to finance England’s war efforts.
Later, governments in Europe started issuing perpetual bonds (bonds with no maturity date) to fund wars and other government spending. The use of perpetual bonds ceased in the 20th century, and currently governments issue bonds of limited term to maturity.
Government bonds in a country’s own currency are sometimes taken as an approximation of the theoretical risk-free bond, because it is assumed that the government can raise taxes or create additional currency in order to redeem the bond at maturity. There have been instances where a government has defaulted on its domestic currency debt, such asRussia in 1998 (the “ruble crisis”) (see national bankruptcy).
Currency risk is the risk that the value of the currency a bond pays out will decline compared to the holder’s reference currency. For example, a German investor would consider United States bonds to have more currency risk than German bonds (since the dollar may go down relative to the euro); similarly, a United States investor would consider German bonds to have more currency risk than United States bonds (since the euro may go down relative to the dollar). A bond paying in a currency that does not have a history of keeping its value may not be a good deal even if a high interest rate is offered.
Inflation risk is the risk that the value of the currency a bond pays out will decline over time. Investors expect some amount of inflation, so the risk is that the inflation rate will be higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by linking both interest payments and maturity payments to a consumer prices index.