Summary for those in a hurry: In comparison to a share, a bond does not represent an interest in a company. With a bond, you simply lend money to a company and are offered a certain, usually fixed, interest rate. In order to be able to invest in bonds yourself, you need a broker through which you can buy (= subscribe to) the bonds. We recommend using a cheap online broker – so that the fees do not exceed the yield. We use the very low-priced OnVista Broker. You can also find other cheap offers using our comparison calculator.
What is a bond?
If you need money for a project (e.g. building a house, buying a flat, buying a car) and do not have it yourself, you usually go to the bank and apply for a loan.
If companies need money (and do not have it themselves) they also go to the bank. However, companies (here, we are not talking about small but rather large ones) have other options to raise money: the issuing of a corporate bond.
If states need money (we rarely speak of millions here, but rather of billions), they do it like companies. They also issue bonds – so-called government bonds.
What all three actors (private, corporate, state) have in common: they need money, but have none (or not enough). That’s why they incur debts.
So a bond is a certain debt. In technical terms, debt is often also called borrowed capital. This may sound less frightening, but it is basically the same.
Why bonds if there are banks?
Now, you will probably wonder why companies do not simply go to a bank and apply for a loan. Most companies – including those that issue bonds – usually do that as well. However, there are several reasons why a company wants to finance itself with corporate bonds in addition to loans from the bank:
- The bank no longer grants a loan. Although this is a bad sign for potential bond buyers (creditors), this case has already ocurred in the past, especially with young companies.
- The bank’s interest rates are too high – the loan is too expensive. With a corporate bond, the financing costs of a company can be reduced.
- The bank does not grant a loan that high – the company needs too much money. This is one of the most common reasons – especially in large companies – for issuing bonds. If many thousands, even tens of thousands, of creditors come together to issue a bond, large sums can be “collected”.
- If the funding is not only provided by one source (e.g. bank), the company is more independent and has more flexibility in choosing the next fundings.
Now you know why companies issue bonds. Now, think about the reasons for governments to issue bonds.
Exactly, point 3 is good advice. States usually need so much money that the banks could no longer bear the responsibility if they were alone in financing the state. This does not mean, however, that banks do not hold government bonds, on the contrary – as government bonds are usually a safe investment – exceptions á la Greece confirm the rule.
How does a bond work?
That is pretty simple. In order to understand it, the following terms, which we will clarify, are important.
- nominal value
As already mentioned, with a bond, many bond buyers (also called bond subscribers or creditors) provide their capital and lend it to the company. The amount a company (or state) needs is thus divided into many equal (“bite-sized”) pieces. The value of each piece is called the nominal. One of the most frequently chosen nominal values is 1,000 Euros.
Example: The volume (total amount) of a bond is 1 million Euros. The nominal value is 100,000 euros. Consequently, the bond is divided into 10 pieces. If the so-called denomination, as in this case, is very high, usually only large investors are attracted, because small investors simply have no possibility, but also no interest, of putting so much money into a single investment.
Of course, it is also important to know how long you lend your money to a company. The length of time a company has your money is also called duration.
While corporate bonds tend to have a short duration (5-10 years), countries also issue 30- or even 40-year government bonds.
In general, long-term financing is preferable to short-term financing, since a company or state can simply “secure” itself financially. For the buyer of the bond, however, a shorter duration has advantages such as a lower risk of not getting the money back. This increased risk through longer durations is often compensated by higher interest rates.
Anyone who lends money to someone else wants interest on it, that’s obvious. While “normal” bank loans usually require monthly payments, bonds work differently.
Interest payments (also called coupons) are also made at regular intervals, mostly annually. At the end of the term, the total amount of the bond is repaid, which is also called redemption.
Of course, there are many more terms used to describe bonds, but these represent the basic knowledge for every small investor.