What is a bond? People seem to talk a lot about Stocks, but bonds are a bit more mysterious. It might surprise you to find out that the bond market is actually larger than the stock market. Then again, it might surprise you that you can invest in something other than a stock. More important than this fact are the most basic questions: Are bonds a good way to make money? Are they safe? What is principle and interest? Pete Andresen, Head of Investment Management at the Andresen & Associates investment firm, explains what a bond is, as well as briefly discussing what their place in your portfolio should be.
What is a bond? Essentially a bond is nothing more than a debt. Each bond consists of two parts: the principal, which is the amount being loaned, and the interest, which is the income earned on the loan. Again, and this is very important, the principal is the money that is loaned, and the interest is the money, beyond what is lent, paid back to the lender to compensate him for the risk he's taking by lending.
Example: Joe says to Frank, "Hey Frank, I need some money to start a business, how about I borrow some from you, and in 2 years I'll pay you back?"
Frank says to Joe, "Well, what's in it for me? All I see is risk."
Joe replies, "Hmm, for every 10 dollars you lend me, I'll pay you back one dollar more than you gave me each year (a.k.a. 10% interest). "
"Wow, what a compelling business deal. That seems worth the risk," says Frank. And thus a bond with a 2 year maturity is born.
If all goes well and the bond "matures" (i.e. reaches the end of the loan term), then the lender gets his money back plus he makes money from the interest. However, if the debtor cannot pay the lender back, then the bond has defaulted (i.e. all the money is lost). That is where collateral comes in -- oftentimes banks, or other issuers of loans, will make the debtor list something that can be used as insurance in case they can't pay back the money. In other words, if I put up my house as collateral on my mortgage, and I can't pay my mortgage, the bank can take my house.
Now, each bond has a "default risk rating," which, as the name suggests, is indicative of how likely it is the bond won't be paid back. If you are a thinking person, or if you like money, it isn't hard to understand that lending money to somebody who is unlikely to pay it back is a poor business proposition. But people still do it. Are these people stupid? ...Maybe, but you have to keep in mind that bonds with high default risk often have high interest rates, and many people can't resist the prospect of a quick buck, even if it means gambling with their money. It's also important to keep in mind that in the modern world there are all sorts of complicated bonds ranging from mortgages to Treasury Bills, and oftentimes the real risk of the more complicated bonds are so (over)complicated that the people selling the bond can convince people that it really isn't that bad a deal. In other words, some people are tricked into taking more risk than they should. (Ever heard of the 2008 Financial Panic?)
Long story short, bonds are IOU's. If you're going to lend someone money in order to make money, we think it's better to play it safe -- especially through mutual funds, but THAT, my reader, is a subject for another day.