Bonds are effectively a loan that the corporation takes out. Assume that a company wants to build a new factory that costs $100 million. Putting aside a syndicated loan of multiple banks, the typical approach is for the corporation to "issue" a bond. Investors that buy the bonds are called bond holders. The bond is a loan that pays periodic interest (annually, quarterly, etc) and at the end of the term (1, 5, 10, 20 years, etc) the full principal is paid back to the bondholders. When the bond is issued (assume in $1,000 increments), there is the coupon rate (what the bond always pays in periodic interest - assume 10%). However, interest rates in the market vary every second, and risk has to be added to bond. The market might require a 15% return on the bond. So while the bond always and only pays 10%, the 15% is the actual return (the 15% is called the yield). To reach the 15% return, a bondholder will only pay $900 for the bond - in the end, the bondholder gets $1,000 compensating for the risk and the extra 5%.
Discussion Question
1. What are some of the bond ratings and what do the mean? AAA, etc.
2. What are the types of risk that bonds can have?
3. Are there safe bonds and super risk bonds? Why and when would we want a safe or risky bond?