This article has been written by expert contributor, Sharesies
A really big loan
Governments and large companies sometimes have the exact same problem as regular people—they want something, but they don’t have the cash to pay for it right now. And just like regular people, one of the ways they can solve this problem is by getting a loan.
If you want to borrow some money, you’d go to a bank, use your credit card, or ask a friend. Big organisations, though, want to borrow a lot more money than you—millions, hundreds of millions, or even billions of dollars. That’s a lot harder to get from a bank.
So rather than borrowing money from one person, these big organisations borrow money from lots of people. To do this, they use bonds.
How bonds work
Let’s say a company wants to borrow a hundred million dollars (big spender 😎). To get this money, it may, for example, create 100,000 bonds and sell them at $1,000 each. Also for this example, say each bond has an agreement to pay $50 once a year (also known as a coupon) for 30 years—that’s the equivalent of an interest rate of 5%.
If an investor buys one of those bonds for $1,000, the company gets their thousand bucks. In exchange, the investor gets $50 a year for 30 years. At the end of the 30 years, they get their thousand bucks back.
By doing this, the organisation issuing the bonds doesn’t have to find a single lender who’s willing to be on the hook for the entire hundred million dollars for the entire 30-year loan.
It’s also more flexible for whoever buys the bond. If an investor buys one of those bonds, they don’t have to hang onto it for the entire 30 years. If they change their mind, they may sell the bond to someone else. They get some cash, and whoever bought the bond will now get the $50 a year.
The amount the organisation has to pay as a coupon will depend on how risky it is to lend them money. If an organisation runs out of money, it won’t be able to pay the people who own the bonds it’s issued. This is called defaulting on bonds.
The more likely an organisation is to default, the more investors will demand in exchange for lending it money. The opposite is also true. That’s why coupons from government bonds tend to pay the least—it’s pretty rare for a government to run out of money (although not impossible).
At the other end of the spectrum, there are bonds called “junk bonds”—the name says a lot! They tend to pay higher coupons than lower-risk bonds, but also have a higher risk of defaulting.
Finally, the price a bond sells for may well be different from the price that was paid for it. Like shares, bonds go up and down in price relative to changes in broader interest rates and risk of default by the issuer.
In general, bond prices tend to move in the opposite direction of other interest rates. If people can get a better return from a savings account than a bond, then they won’t pay as much for that bond—what would be the point? But if the bond is giving a better return than a savings account, then people may pay a premium in order to get that return.
Why people like them
Some people invest in bonds because they tend to be more predictable than shares. An organisation is making a very clear promise when they sell bonds—they’re going to pay a specific amount, every year, for a certain number of years.
Of course, this comes with less opportunity. If a company sells some bonds, then does really well and makes heaps of profit, investors who purchased that bond will still get the same amount as originally promised. In exchange for less risk, investors receive stable payments.
To wrap up
So those are bonds. To summarise, they’re loans, except investors are the lender, not the borrower, and they’re just lending a little bit, rather than the entire loan. Bonds are usually relatively stable, but they don’t have the opportunities for higher returns that some higher-risk investments have. What’s most important, though, is considering if it aligns with your risk profile and investing goals after all.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.
Sharesies is a wealth development company that provides access to share markets in the US, Australia and New Zealand. The Sharesies platform offers a wide range of 8,000+ companies and funds to invest in from 1c, and has been joined by more than half a million investors with a collective $2B funds under management. Sharesies is a Certified B Corporation®.