How A Bond Works

ion-bond-banknote-examplesThis article will aim to explain in simple terms how bonds work and how they can effect the economy.

Let’s explain what it is:

Let’s say a city needs $1 million to build a bridge.Not many people can afford to give them $1 million, but what the city does is start by creating a legal contractual obligation. It breaks this obligation¬† down into 1,000 pieces and then asks people like you (the investors) to buy a piece of the project for $1,000/piece. In this case, each bond represents a $1,000 loan that you give the city, and by selling all 1,000 pieces the city gets their $1 million.

Cool, now they have the $1 Million, and begin building the bridge!!!

What the city has created above is called a bond. Each bond has what is called a “coupon” which represents a rate of interest that is usually paid semi-annually (it is a form of dividend). Let’s say the coupon for the “Bridge Project” bond is 10% yearly for 20 years. What this means is that since you purchased 1 piece (or 1 bond) for $1,000; you will receive $10 every year for 20 years and at the end of the 20th year, you will receive the $1,000 initial investment back from the city. Since the bond is semi-annually, they will pay you $5 every 6 months.

Now please pay close attention because by understanding what is written below; you will thoroughly understand how interest rates effect the United States Economy.

Let’s say 3 years later, the city needs more money for the bridge because $1 million was underestimated and they need another million. But within these 3 years, the interest rate has increased. The interest rate is now 15%, so the company will have to issue 1,000 new bonds (legal contractual obligations) at 15% interest that cost $1,000 each. You want the 15% bond but are stuck for another 17 years at 10%. If you want the new 15% bond, you need to sell the 10% bond you currently own. But you can’t sell it at $1,000 because another investor can just buy the 15% bond with that money. This will cause you to “discount” your 10% interest bond, so instead of selling the bond at $1,000 you would sell it at $800 for example.

The idea here is that since interest rates went up on the new bonds, the older bonds will have to be discounted in price.
If in 20 years, it is time for the city to pay off the 10% bonds, but if they realize that they don’t have the money to do so, it can cause a default and bankruptcy.

Bonds are also issued by states, countries and companies. The interest rates of the dollar effect the interest rates of bonds, and the Federal Reserve Bank is in charge of setting the interest rates.


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