Bonds Secrets: Tips and Basic Terms You Must Know
There are several channels you can invest in the New York Stock Exchange: stocks, bonds, warrants, options and many more. This post will talk about one of the popular: bonds. In order to really know what is a bond and which bonds to choose from, you need to know some basic terms, so you can know what is the difference between "good" bonds and junk bonds. Some of the information you need to know you will find in this post, but remember there are many other terms which are not mentioned here, like eurobonds, infrastructure bonds, us savings bonds, fixed rate bonds and more. If you want to know all about these terms and learn in depth what are bonds, you can download our online stock market course.
A company wishing to raise capital has many alternatives. The company can take out a loan from a bank or financial institution, or raise funds from the general public or other sources.
Just as a person who leases his house is entitled to ask for rent, a person who lends money is entitled to ask for something in return. This "rent" that is paid for money is called interest .
Example A: If Bank A lends Mark $10,000 for a year, at the end of the year he must pay the bank the amount of the loan, called the principal, plus an additional sum (such as $2,000), which is called interest.
Example B: If Bank A lends Mark $20,000 for a year at 20% interest, at the end of the year he must pay back the $20,000 principal, plus $4,000 in interest. If the loan extends for two years, the interest will double. In other words, Mark will pay $4,000 in interest at the end of the first year, and an additional $4,000 at the end of the second year. If Mark borrows the money for only half of a year, he pays the bank only half as much interest ($2,000).
Monthly Interest = Yearly Interest/12
To calculate the interest over a period of several months, multiply the monthly interest by the number of months in the period.
Factors Affecting the Interest Rate
The Time Factor: The longer the loan period, the higher the interest rate will be, resulting in higher payment of interest for loans. This means that the interest rate for a period of one week is always lower than the interest rate for 20 years. The Risk Factor: The interest rate therefore reflects the lender’s estimation of the probability that the loan will be repaid. The greater the risk of the borrower (as estimated by the lender), then the higher the "fee" that the lender will charge for the use of his funds, meaning that the interest rate could increase.
The base interest is the interest rate charged by the US central bank, otherwise known as the Federal Reserve Bank, on loans to other banks (also called the discount rate). The interest rates charged by the banks on loans to their customers are derived from the discount on that interest rate.
When a Firm borrows money from a bank, it gives the bank a bond. This document serves as proof of the firm's commitment to pay back the loan at a set time, and at a predetermined interest rate. Interest is the money that the firm must pay for use of the bank’s funds. If Bank A loans firm X $100,000 on January 1, 2008 for one year at 5% annual interest, the firm gives the bank a bond stating that the firm will repay the $100,000 principal, plus $5,000 interest, by December 31, 2008. In other words, the bond is redeemed for $105,000 on December 31, 2008. Unless stipulated otherwise, the bank has the right to sell the bond to any other party. At the end of 2008, the firm will have to pay $105,000 to anyone who presents their bond for redemption. After the debt has been repaid, the firm receives the bond and nullifies it, so that it cannot be used to claim a different debt.
As stated above, purchasing a corporate bond is equivalent to lending money to a company. Just like banks granting a loan to a company, a bond purchaser expects to receive a proper fee for the use of his funds. The fee depends on the duration of the loan and the bond purchaser’s estimation of the risk involved in lending the company his money (meaning his estimation of the probability that he will be repaid). Bondholders usually expect a larger return from the company than might otherwise be obtained from a bank deposit.