Corporations and government entities must have funding for their land, buildings, equipment, operating expenses and ongoing projects. One of the major sources of funding is through the debt market where they can issue debt instruments or bonds. Let’s break down how these bonds can generate income for investors.
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How Bonds Fund Corporations and Other Entities
Corporations as well as local and state governments, including the federal government, issue bonds, which are long-term debt instruments, as a way to borrow money from investors. Corporate bonds can be fixed rate, variable rate or zero coupon. These bonds and those of governments are used to finance the issuer’s plant, equipment and operations. In exchange, interest and principal payments will be made to investors on specific dates.
Although many bonds are long-term in nature, they have varying maturity dates. Some have a maturity date of 30 years, but many have shorter maturities. At maturity, the entity that issued the bond repays the bondholder the principal of the bond. This is called the par value or face value and usually represents the amount of money the firm borrows and promises to repay on the date of maturity.
Each bond does not represent the total amount of money the company or other entity borrows. They could issue $10 million in bonds and denominate each bond in $1,000 increments. Par values can also be in other increments that vary in amount.
When a bond is first issued by a government or corporation it is sold on what’s called the primary market. However, most bonds are bought and sold in the secondary market. That’s an over-the-counter market, not an exchange like the New York Stock Exchange or Nasdaq.
The Coupon Interest Rate
During the life of the bond, investors are also paid the coupon interest rate, which is set and fixed when the bond is issued. Bonds are called fixed-income securities because the coupon rate does not change. This rate is based on prevailing market interest rates.
The coupon interest payment that investors receive is calculated by multiplying the face, or par, value of the bond by the coupon interest rate. For example, if the par value of a bond is $1,000 and the coupon rate is 6%, you multiply $1,000 x .06 to find the coupon payment of $60. Coupon payments are usually made to investors every six months.
Not all corporations or even government entitites have the same degree of risk for investors. If the company is riskier than blue-chip companies, a risk premium would be added to the coupon rate. The risk premium is the additional return that investors demand for companies that carry more risk. That sounds like a good thing but only if you are an investor with a higher tolerance for risk. Speculators in the financial markets have an almost infinite tolerance for risk.
Bond Prices and Interest Rates
Bond prices and interest rates have a negative, or inverse, relationship. If you are in an environment where interest rates are trending up and exceed the interest rates of older bonds that are the same type and have a similar duration then the price of the older bond decreases because it is making lower interest (coupon) payments to investors.
Investors in the secondary market will only buy the older bond if it is sold at a discount. A discounted bond is one selling for lower than its par value. Investors will also prefer to purchase newly issued bonds with high interest rates and will sell their old, lower coupon rate bonds. The situation is reversed if interest rates start to fall.
Bond prices represent the present value of bonds with an eye toward future value since bond prices converge to par at maturity. Bond yields represent the return the investor earns on bonds. Investors will sell old, low-yielding bonds in times of higher interest rates.
Most corporate bonds today contain a call provision. The call provision gives the company that issued the bonds the right to redeem them early at a time specified in the bond contract. The call provision specifies that the issuing company pays the bondholders a premium or an amount greater than the par value when they are called.
Bottom Line
Corporations and other business entities issue bonds to borrow money from investors. In exchange, interest and principal payments are paid to investors on specific dates. There are many types of bonds in addition to corporate bonds. These include Treasurys, municipal bonds, federal agency bonds and foreign bonds, among others. Investors usually have bonds in their portfolios to offset riskier stock. Bond market traditionally trend upward when stock markets go down. Though this has not been the case during the high interest rate, inflationary period in 2022.
Tips for Investing
- A financial advisor can help you decide if bonds make sense for your financial plan. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s inflation calculator will help you see the effect of inflation on your investments.
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