What are Bonds?
Overview
This module aims to offer deeper insights into bonds as a form of investment. It will take a look at:
- Defining Bonds
- Bonds vs Bank Loans
- Bonds vs Shares
- Why Should I Invest in Bonds?
Defining Bonds
When the need arises to raise money, issuing bonds is one of the ways that companies do this. As a product, a bond gives something for investors to invest in, and by doing so provides the company with the funding it requires.
The investor concurs to give the business a precise amount of money for a specific timeframe in exchange for broken up interest payments at chosen intervals. The investor’s loan is then paid back when the loan reaches its maturity date.
The choice to issue bonds rather than selecting other methods of raising money can be motivated by many factors.
Comparing the characteristics and advantages of bonds versus other common ways of raising cash offers some insight into why companies usually look to issuing bonds when they need to raise cash to fund corporate activities.
Bonds vs Bank Loans
Borrowing from a bank is possibly the approach that many people think of first when they need money. Therefore, the question would then be asked, “Why would a business issue bonds as an alternative to borrowing from a bank?”
Like people, companies can borrow from banks, but issuing bonds is often more attractive. The interest rate businesses pay bond investors is frequently less than the interest rate they would need to pay to get a bank loan.
Since the money paid out in interest reduces corporate profits and companies are in business to generate profits, decreasing the interest amount that must be paid to borrow money is an important consideration. This is why a company would issue bonds.
Issuing bonds also gives companies considerably greater freedom to operate as they see fit because it releases them from the restrictions that are often attached to bank loans. Consider, for example, that companies are regularly required to agree to a variety of limitations by lenders, such as refraining from issuing more debt or not making corporate acquisitions until their loans are fully paid off.
Limitations such as these can hinder a company’s ability to do business and limit its operational options, and issuing bonds allows companies to raise money with no such strings attached.
Bonds vs Shares
Issuing shares, which means giving proportional ownership in the company to investors in exchange for money, is a popular way for corporations to raise money. From a corporate perspective, perhaps the most attractive feature of issuing shares is that the money generated from the sale of shares does not need to be repaid.
There are, however, downsides to issuing shares that may make bonds the more attractive option. In terms of bonds, companies that want to raise money can keep on issuing new bonds as long as they are able to find investors willing to act as lenders. This act of issuing new bonds has no impact on ownership of the company or how it is operated.
Share issuance, on the other hand, puts extra shares in circulation. This means that future earnings must be shared between a larger pool of investors. The consequence of this can be a decline in earnings per share (EPS), meaning the owners’ have less money in their pockets.
EPS is also one of the measurements that investors look at when calculating a firm’s health. A declining EPS number is generally not seen as a positive development.
Issuing additional shares also means that ownership is now dispersed across a greater number of investors, which usually makes each owner’s share worth less money. Since investors buy shares to make money, diluting the value of their investments is not a favorable outcome. By issuing bonds, companies can avoid this outcome.
Why Should I Invest in Bonds?
There are many reasons why anyone would consider investing in bonds. As an asset class bonds are considered as interest bearing instruments. The concept behind a bond is that you make an investment in exchange for a known and frequent receipt of an interest payment.
The known interest payment is very attractive in that it is an investment which gives you annuity income. Consider the importance of knowing when and how much interest is due, in the eyes of someone who has retired and is banking on knowing exactly when and how much they will receive.
Investing in bonds is, however, not always that straight forward. There are a few other market factors at work which may be harmful to your investment if not understood or accounted for. When considering investing in bonds it is important to consider the following:
• Understand that bonds are not the same as money market deposits. Bonds do not necessarily protect your invested funds the way money markets can.
• Bonds are “IOU’s” issued by companies, and as such what really happens is the company now owes you money, and in return for lending the funds to them, you will earn a coupon (interest). The more risky the investment, the higher the return needs to be.
• The financial soundness of the bond issuer.
• Your own investment horizon. If you do not intend to hold a bond to maturity, your investment will be exposed to more risks. In the same breath, you want to avoid being forced to liquidate a bond position.
• What is the true underlying motive: investing or trading?
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