How Do Bonds Work

The first type of bonds to ever be issued are government bonds. Many finance books and guides term the bond to be financial instruments, policy of raising money, assets of people, etc. However, many of us fail to realize the basic logic behind a bond. A bond is essentially a loan that a common man gives to a body corporate or a governing body, and is rewarded with interest upon its expiry period. Thus, the phrase 'purchasing a bond', actually means 'giving a loan'. There are a few other factors and variations that have been introduced in the working of a bond in recent past. The basic functioning however remains the same.

What Are Bonds?
As mentioned above, bonds are nothing but loans that are provided to governments and body corporates by the common man. The bonds which are debt instruments, are issued in a primary market by corporations or governments. The corporation or government which originates the bond is known as issuer of the bond, and a person who purchases it is known as the owner of the bond. In the primary market, the bonds are issued by underwrites, financial institutes, banks or brokers. The Central Bank of a particular nation usually issues government bonds on behalf of the Treasury Department of the Government. Bonds can be issued at 3 types of prices, namely, at par, at discount, and at premium. When a bond is issued at its face value, it is termed as 'issue at par'. The discount issue is issue at lower value than the par value and premium is a greater value than the par value.

How do Bonds Mature?
The time period of a bond begins on date of issue and ends on maturity date. In the time period between date of issue and date of maturity, the interest is paid to the owner of a bond on monthly or yearly basis. In some cases, interest is accumulated and then paid to the owner on date of maturity. For most of the bonds, rate of interest is fixed, but in case of a floating rate bond, the rate of interest is decided on the basis of credit markets. On the date of maturity, the ownership automatically expires and the principal amount is remitted to the owner.

How Do Bonds Trade?
One can also trade bonds in the secondary money market for gains that are more than the investment. Trading price of a bond depends on credit rating, credit score, and issue price of the bond. The credit rating is expressed with the help of an alpha numeric figure. For example; AAA is a rating for a lowest risk bond. The credit rating agencies have different formulas to calculate rating and scores of a particular bond. Bond of a body corporate that has not financially established itself is bound have a low credit rating and score. On the other hand, the credit rating of a bond issued by a corporation that has a very good performance is bound to be very good. In the same manner, the bonds of a very stable government have a high credit rating as compared to that of a volatile government.

Types of Bonds
The following are some of the common types of bonds.

• Government Bonds: The bonds that are issued by the government are known as government bonds. These bonds are sometimes issued for a specific purpose, like funding an infrastructure project. Government bonds carry a very high credit rating and are issued to a discounted price in many cases.
• Municipal Bonds: These type of bonds are issued by local governing bodies for specific purposes, like building hospitals or providing other civic amenities. These bonds again have a high credit rating and market value. In cases of government and municipal bonds, the owners of the bond qualify for tax exemption.
• Corporate Bonds: The bonds that are issued by corporations and companies are titled as corporate bonds. The corporate bonds can be secured or unsecured in nature. The secured bonds are 'tied down' to specific assets of the company. If the company goes into liquidation, such bonds are repaid by liquidating the assets of the company. The unsecured bonds in case of liquidation, may or may not be repaid, and are thus high risk bonds.
• Floating Rate Bonds: Floating rate bonds are the ones which do not have a fixed rate of interest. Most of the floating rate bonds have a low credit rating and less market value.

The bonds are used for many purposes by their owners, sometimes they are used as a source of income, investors use them as commodities of trade, and individuals use them as assets that can be pledged as collateral with lenders.