Bond

Basically, an IOU issued by a company in order to raise money. When you buy a bond, you are essentially loaning money to a company with the understanding that you will receive what you invested along with a fixed amount of interest (also called the coupon) at some future date. The future date when you receive this cash is called the bond’s maturity date.

Example

Here is a simple example to help you understand the concept. Let’s say your best friend wants to expand his business and he needs $5,000 to do this. He promises that he will repay you $5,250 a year from now. In this case, the bond is represented by the $5,000 loan you gave to your friend to help him raise money for the business expansion. The interest rate (or coupon) was 5% and the maturity date was 12 months from the date the bond was purchased.

Fixed Income

Many people invest in bonds because bonds offer a stream of steady income (e.g., fixed income). For example, suppose you invest $10,000 in a bond with a coupon of 5% and a maturity of 10 years. Every year for 10 years, you would receive a fixed income of $500 (5% of $10,000). At the end of 10 years, you would get back your $10,000 initial investment.

There are two interesting things to note about this example:

  1. InflationInflation is a bond’s worst enemy. Note that you lose control of your $10,000 for 10 years and you will be able to buy less with your $10,000 after a decade has passed (see: Time Value of Money). Moreover, the $500 interest you earn also worth less each year. The 5% interest is supposed to make up for this and give you a little extra to keep your money growing. However, if the average inflation rate over the 10 years period is over 5%, you will effectively lose money on your investment.
  2. Compounding – Unlike a savings account where the interest you earned is automatically “reinvested,” you cannot as easily take advantage of compound interest with bonds. With bonds, you will have to make an effort to purchase more bonds with the money you earned, assuming that you earned enough to meet the minimum purchase requirement.

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