A bond is a debt instrument issued by a government entity or a corporation to raise capital.
The purchaser of a bond is a creditor and the bond issuer is the debtor.
When a bond is issued, it is sold to investors for the first time.
The investor pays the issuer (government or corporation) for the bond.
Say, for example, that General Electric (GE) wants to raise money to build a new plant. They issue a $100,000,000 15-year, 8% corporate bond. Assume that 2,000 people buy a portion of the $100,000,000 bond issue. The bond buyers are paid 8% interest on their investment each year.
At the end of 15 years, the bond matures. GE repays the entire $100,000,000 to the bondholders. All of the bondholders are repaid their portion of bond issue.
A bond is issued to the public for the first time in the primary market. The GE bond example is a primary market transaction. GE (the issuer) gets the sale proceeds from the investors. They use the proceeds to build the new plant.
2. Understand how bonds are issued.
Bonds are issued with a certificate in electronic form.
The par value is the dollar amount stated on the face of the bond certificate.
The annual interest rate paid to the investor is also included on the bond certificate, along with the maturity date.
Once the bond is sold to the initial investor in the primary market, the bond can be traded between an unlimited number of investors. Bonds are bought and sold between investors in the secondary market.
Assume that Bob owns an IBM corporate bond. Bob sells the bond to Sue. The sale between these two investors is a secondary market transaction.
Bonds trade based on a market price in the secondary market. The price is driven by demand, the interest rate on the bond and the credit quality. If a bond is trading at a discount, the market price is less than $1,000 per bond. Premium bonds are bonds that are priced above $1,000 per bond. An investor who sells a bond may incur a gain or a loss.
Par value is $1,000. An investor can buy bonds in any multiple of $1,000 ($5,000, $100,000, etc.).
The issuer receives the sales proceeds from the investor, and the investor earns interest each year.
On the maturity date, the original investment is returned to the investor.
Assume that Acme Corporation issues a $1,000 6% bond with a maturity date of 5 years.
The investor earns $60 in interest each year ($1,000 multiplied by 6% = $60).
After 5 years, the issuer repays the investor $1,000.
The last $60 interest payment is also paid on the maturity date.
The investor receives a total of $1,060 at maturity.
Invest in Bonds
4. Consider a gain or loss on a bond sale.
If an investor sells a bond before the maturity date.
They are selling the security at the current market price.
The market price may be higher or lower than the par value (issue price).
Selling at a premium: Assume that an investor purchases the newly issued bond at $1,000.
He or she decides to sell the bond after 3 years, which is before the 5-year maturity date. Assume that the market price is $1,050. The gain is ($1,050 sales price – $1,000 issue price = $50 gain).
Selling at a discount: Assume that an investor purchases the newly issued bond at $1,000. The investor decides to sell the bond after 3 years, which is before the 5-year maturity date. This time, assume that the market price is $980. The loss is ($1,000 issue price – $980 sale price = $20 loss).
Remember that bonds can trade between investors. Assume that an investor buys a $1,000 par value bond from an investor at $950. The investor sells the bond to another investor 2 years later at $1,100. Your gain is ($1,100 sales price less $950 = $150 gain). Note that your gain is based on your cost of $950- not the $1,000 issue price.