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Have you ever borrowed money? Of course you
have! Whether we hit our parents up for a few bucks to buy candy as children
or asked the bank for a mortgage, most of us have borrowed money at some
point in our lives.
Just as people need money, so do companies and governments. A company needs
funds to expand into new markets, while governments need money for everything
from infrastructure to social programs. The problem large organizations run
into is that they typically need far more money than the average bank can
provide.
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The solution is to raise money by issuing bonds
(or other debt instruments) to a public market. Thousands of investors then
each lend a portion of the capital needed. Really, a bond is nothing more
than a loan for which you are the lender. The organization that sells a bond
is known as the issuer. You can think of a bond as an IOU given by a
borrower (the issuer) to a lender (the investor). Of course, nobody would
loan his or her hard-earned money for nothing. The issuer of a bond must pay
the investor something extra for the privilege of using his or her money.
This "extra" comes in the form of interest payments, which are made at a
predetermined rate and schedule. The interest rate is often referred to as
the coupon. |
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The date on which the issuer has to repay the
amount borrowed (known as face value) is called the maturity date. Bonds are
known as fixed-income securities because you know the exact amount of cash
you'll get back if you hold the security until maturity.
For example, say you buy a bond with a face
value of $1,000, a coupon of 8%, and a maturity of 10 years. This means
you'll receive a total of $80 ($1,000*8%) of interest per year for the next
10 years. Actually, because most bonds pay interest semi-annually, you'll
receive two payments of $40 a year for 10 years. When the bond matures after
a decade, you'll get your $1,000 back.
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