Bonds are typically one of those ‘things you’ve heard of’ but aren’t quite sure what they are. So today’s blog is just going to give an overview of what a bond is in the general term and how they work.
What is a Bond?
In it’s purest form a bond is quite simply a legal agreement between two parties in which an investor will loan the other party a sum of money for a set period of time. This bond states the borrower has to repay a set amount of money on a recurring basis to the investor and a one-off final sum at the end of the set period of time. So in principal it’s a “fancy loan” 🙂
How do Bonds work?
There are a few methods in which Bonds can work, however typically they operate in three key stages:
Stage 1 – The Terms and Agreement
Firstly, the two parties will agree on:
- The amount of money to be loaned
- The period of time the money will be loaned for
- An ongoing and recurring amount (known as ‘coupons’)
- The payment dates for the recurring amounts
- The amount of the one-off final sum when the set period of time ends
Stage 2 – Recurring Payments
Once the terms of the Bond has been a agreed, the borrower will then pay the ongoing fees for the set duration of time. This ongoing amount is typically only the interest on the loan and is usually paid twice a year.
Stage 3 – The Final Payment
Once the set period of lending time has ended and all recurring payments have been made, there is just the final one-off payment to be made to the lender. This is usually equivalent to the amount of money borrowed at the beginning and once paid, the Bond is complete.
A working example of a Bond
So you can see this in practice I’m now going to show you a working example of how a Bond typically works. To make this as simple as possible I’m going to use small numbers, but most Bonds are worth MUCH more money than this and can even be traded on financial markets!
So as stated above, firstly the investor and borrower must agree terms – for this scenario let’s say these are the agreed terms:
- The amount of money to be loaned = £1000
- The period of time the money will be loaned for = 10 Years
- An ongoing/recurring repayment amount = £200 (20% Interest on £1000)
- The payment dates for the recurring amounts = Twice a Year
- The amount for the one-off final sum when the set period of time ends = £1000 (The Initial Amount Borrowed)
Once these terms are agreed, the borrower must now pay back £200 twice per year for the next ten years. Once those ten years have come to fruition the borrower must then pay the final £1000 and complete the Bond. The process is really that simple, as I said before it’s a “fancy loan” in essence!
As you can see the reason investors like bonds is because it is legally guaranteed profit on an initial amount of lent money. This lender only loaned £1000 then within 10 years they will have made an easy £4000 of passive income and finally got their initial investment back of £1000. It’s very simple money making for a lender and is protected by law.
On the other side, the borrower has got their initial lump sum of money up-front, with only small recurring payments to pay, knowing within the set period of time they can save for the final payment amount without worrying about having high constant repayments to stress over – therefore is a great method for borrowing money.