No, I am not talking about James Bond. No, I am not talking about chemical bonds.
I am talking about the bond, as in I OWE YOU!
Quite literally, that’s what a bond is. If I issue a bond and you buy the bond, then I owe you.
How much do I owe you? Well, it would be the amount you purchased the bond with, the face value, plus the interest that I have to pay you, the coupon. If the bond has a ten year duration, then every year for ten years I give you an amount of money (coupon), that is the face value times the coupon rate, the interest rate at which the bond issuer has to pay the buyer. (Most of the bonds’ interest are paid annually or biannually.) At the end of ten years, I pay you back the amount you purchased the bond with. (the face value)
So who issues bonds?
The governments and corporations do. It is a common misconception that people believe government bonds pertains no risks and return is guaranteed. Although government bonds often have good reputations on their safety, the belief is fundamentally incorrect.
Why does the government need to issue bonds? Before I answer the question, there is one very important distinction to be made. The Federal Reserve is NOT part of the government! The federal reserve can print money however they want, but the government cannot. Now, running a country takes a lot of money. People working for the government have to be paid; bridges and roads have to be built; armies have to be sustained… When the taxes citizens pay to the government isn’t enough to do all of that (government in deficit), the government needs a way to find money. And so, they issue bonds. However, bonds are not always issued from the federal government. There are municipal bonds issued by town governments, for smaller projects, perhaps providing free wifi for hospitals, as supposed to federal bonds, issued by the federal government for larger projects, say putting a man on the moon.
Corporations issuing bonds is just an alternative to borrowing from a bank. Sometimes, banks don’t want to lend out a large amount to one company. Then these companies have to find other sources of financial support.
However, for bond buyers, saving money in the banks is different from “saving” money in bonds. As expected, there are risks to all bonds. Corporations could go bankrupt; revolutions could occur. So how can people interested in buying bonds know how much risk there is to invest in a bond? There are three top agencies that give bonds ratings: Moody’s, Standard and Poor’s, and Fitch Ratings.
As we can see from the chart above, return from bonds issued by companies with a AAA rating is almost guaranteed. However, for companies with a rating lower than B, buying their bonds is quite like gambling, high risk, high return. The line drawn to separate safe bonds and unsafe bonds is under BBB. Bonds with ratings lower than BBB are known as junk bonds. You might have heard of this name before because it is commonly discussed. This is where many people look into hoping for good luck to strike. Not all junk bonds are sketchy little companies running on gray area next to legality as you are probably imagining. In fact, there are many known companies in the junk bond category.
You can see many huge airlines in the bottom ratings. Why? You think they are making lots of profits right, from all the unaffordable plane tickets? However, it is very important to keep in mind that bonds are very long term investments. Bonds usually have a span for over 10 years, and in the ten years you are keeping the bond, you only receive coupons from the company. Now try to find very long lasting airlines. Not a lot right? Search for the airlines that were once prosperous but ultimately died. Probably many. Because the commercial airline business wasn’t born for a long time, and yet the competition is extremely intense. Are you still willing to buy bonds from airlines, knowing that 5 years from now, the names of dominant airlines could be very new? If the airline dies before their bond expires, then all you have in your hand is several years of coupon, which could be a fair amount considering the high coupon rates of the low rating companies. However, the money you initially put in would be all gone. Wouldn’t it be devastating for airline bond holders if Elon Musk actually develops that vacuum transportation tube? For them, sci-fi movies are probably the last movies they want to watch.
“Hello! Wall Street here.”
“This is James Bond.”
” Yeah? How’s the rating looking for James… um, Inc?”