What is a bond?
The second, perhaps most common financial asset is a bond. Unlike a stock, here you do not own the company, but instead own a promise to pay you back your investment plus interest. Holding a bond is in essence being a small bank. You send a company a set amount and in return they pay you back a agreed amount of interest plus your initial investment.
Great, so guaranteed money. But… what can do wrong?
Like a holding a stock, if the firm that you hold the bond with gets into financial difficulty, you may not receive your investment back.
Now before we finish here, it is important to explain that bondholders are higher up the pecking order compared with shareholders. There is a priority of claims1, this should always be checked before investing in a bond because it can be dependent on numerous different factors but generally speaking, the priority of claims, in simple terms, who gets paid back first if the company falls into financial difficulty is something like this,
- Administration expenses associated with the company going bankrupt.
- Unsecured claims arising after filing for bankruptcy.
- Wages, salaries and commissions.
- Contributions to employees benefits.
- Tax claims.
- Secured and unsecured claims.
- Preference and then ordinary shareholder claims.
Bondholders fit into 6, secured claims have higher preference that unsecured and these investors often receive less interest.
Like holding stocks, bonds differ in risk, you could buy a bond that promises lots of interest but is highly risky or you could buy a bond that offers a little interest but it is highly secure. Companies are given ratings so you know how likely they are to pay back but remember these are only ever guides and companies that are rated well can still fall into financial difficulty.
Types of bonds.
There are many different types of bonds, Treasury Bills is a term often used in finance textbooks, put simply, this is borrowing from the United States Treasury, and the term has often stayed for other governments/central banks who offer bonds. These bonds are generally used to fund large state-backed projects. Government bonds are often less risk as not to be paid back generally means the government going into financial difficulties, whilst this may seem unlikely it is not uncommon, there are numerous examples when governments from across the world have had to go bankrupt.
Bonds can be inflation backed, based on types of underlying assets, for example mortgages and infamous mortgage backed securities that have been the focus of the 2008 financial crisis. But the premise behind all bonds, is that you lend an entity a sum of money, and they promise to pay it back with interest, the interest payments are often called coupons.
If you would like to know more about finance, we run a Accounting and Finance 101 course, available as an introduction to the financial markets, how to read accounting statements, and how to complete basic research, see here for more details. To learn specifically about bonds, please see more information to our online class, how to invest in the bond market?
1Proper legal advice should be consulted, we are not lawyers and this priority of claims is a general framework that may not be completely accurate, is subject to change and may differ across companies.