You may have heard of stocks and bonds but do you know the difference? A few months back we talked a little bit about what a stock is (click here to read the post) so now let’s take a look at bonds.
One of the primary differences between a stock and a bond, at its most fundamental, is that when you hold stock you own a portion of the company. When you hold a bond what you have is a loan to that company.
If you are a company and you need money to do research or purchase new equipment you might sell off some of your company as stock. This will bring in cash that is outside of normal business income. But then you, the company, are in a position where several other people now have an ownership stake, possibly with rights to vote on the direction of the company. Maybe you don’t want that, or you’ve got no stock left to sell. Or, maybe your company’s reputation or growth potential is not what it should be to bring in the amount of cash you need. Then you might opt to issue a bond.
Essentially a bond is an instrument wherein the purchaser is told up front what the face value of the bond is, and when exactly it will be paid back, and what percentage will be earned and when those payments will be made. This is good for the company because it knows exactly what and when it will owe back to the bond holders.
Why not just borrow from a bank, you may wonder? It may be difficult for a company to borrow enough cash from a bank, especially if the amount is quite high. And in the case of the government it can’t exactly borrow from itself so it issues bonds to do things like build roads and build schools.
For the investor, a bond is often considered “safe”. This is because of the certainty of the payback arrangement. However, that portion of cash is tied up in that instrument for a fixed time frame. Those funds tied up in bonds then can’t be used to purchase stock or put a down payment on a house, for instance. And, if you are able to sell your bonds you may have to take less than you would have received if they were allowed to come to maturity.
Where do bonds come from? There are several different entities that can issue a bond.
Government –The U.S. can issue bonds and these are generally considered the most secure of financial instruments.
Municipal – These can also be local governments, states, and municipalities.
Corporate – These are issued by corporations and can be sold either on a public market or “over the table” – essentially a private market where bonds are bought and sold.
Agency – These are bonds issued by government agencies, like the water company.
Now that you know where bonds come from you might have heard a few types which we can illuminate. Of course, as with all financial instruments within these types are several sub-types and details, too many to discuss here.
Puttable – This is a type of bond where you can sell it back to the company before the maturity date.
Callable – This is a type of bond where the company can pay you back earlier than the maturity date.
Zero-Coupon – “Coupon” is what the percentage periodically paid out is named. So, a zero-coupon bond is one where there is no percentage paid out. But it is sold at a lower rate than the face value. So, you may purchase a bond worth $100 for $98.75. When it matures you will get back your investment of $98.75, plus $1.25.
Convertible – These are bonds that can be turned into stock, and how and when that is done can be very complicated, but suffice to say that this type of bond allows one to go from a lender to and owner of the company.