At some point everyone needs to borrow money. You've done it thousands of times, taking money from the bank, from friends and especially over the years from your parents. With this fact in mind it shouldn't come as a surprise that even big corporations and governments sometimes need to borrow money as well. This is where bonds come into the picture.
What Are Bonds?
When large organizations, such as companies or national governments, need to borrow money they usually require an amount greater than what any bank can loan. In order to acquire the money needed, these organizations issue bonds. US savings bonds are an example of government issued bonds. You, as the investor, can then buy these bonds, essentially lending money to the issuer of the bond. However, you will not go unrewarded for lending this money. The benefit of bonds is an agreed upon compensation price (interest) granted to the investor for providing this loan. The issuer of the bond must pay back to the investor the full amount lent (the money paid for the bond) as well as a little extra in interest payments. These payments are made at a predetermined rate and schedule. The interest on bonds is referred to as coupon, the amount borrowed by the issuer of the bond is known as the face value of the bond, and the date on which the issuer has to repay the bond in full is the maturity date.
Difference Between Stocks And Bonds
While bonds are a safe way to invest your money, they will not make you rich quick. Bonds are considered fixed-income securities since the investor knows the exact amount of money he will get back at maturity. This fact is the essential difference between stocks and bonds. Stocks are considered equity and bonds are considered debt. When you purchase equity you, as the investor, become an owner of the company in which you invested. You acquire voting rights and the right to a percentage of any future profits for the company. On the other hand, when you buy bonds or debt, you become a creditor of the company. The advantage to being a creditor is that you have a higher claim on the assets of the company. If a company goes under then you get paid before the shareholder (stock investor). However, if a company does well, then as a creditor, unlike a stockholder, you do not share in a percentage of the profits. You only get the principal (what you originally paid) plus the agreed upon interest. So while there is less risk in owning bonds there is also less potential for earning large amounts of money since bonds yield a lower return than stocks that do well. Yet, while bonds do not have the potential earning power of stocks, many people prefer them over stocks as the place to invest retirement savings since this is money they cannot afford to risk loosing.
Article written by Nicole Sivan