Refresh May 06, 2024 6:59 AM ET
What Exactly Is a Bond?
from SmartMoney University
Technically speaking, a bond is a loan and you are the lender. Who's the borrower? Usually, it's either the U.S. government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate -- to fund the federal deficit, for instance, or to build roads and finance factories -- so they borrow capital from the public by issuing bonds.
Now for a little bond-speak. When a bond is issued, the price you pay is known as its "face value." Once you buy it, the issuer promises to pay you back on a particular day -- the "maturity date" -- at a predetermined rate of interest -- the "coupon." Say, for instance, you buy a bond with a $1,000 face value, a 5% coupon and a 10-year maturity. You would collect interest payments totaling $50 in each of those 10 years. When the decade was up, you'd get back your $1,000 and walk away.
A key difference between stocks and bonds is that stocks make no promises about dividends or returns. General Electric's dividend may be as regular as a heartbeat, but the company is under no obligation to pay it. And while GE stock spends most of its time moving upward, it has been known to spend months -- even years -- going the other way.
When GE issues a bond, however, the company pledges to pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity, you know exactly how much you're going to get back (in most cases, anyway. We'll discuss some exceptions later). That's why bonds are also known as "fixed-income" investments -- they assure you a steady payout or yearly income. And although they can carry plenty of risk, this regular income is what makes them inherently less volatile than stocks.
