Bond Basics: How Bonds Work
Whenever you drive down one of America’s highways, or see a factory expanding in the city where you live, you’re seeing bonds in action. The fact is, bonds are used by both the federal government as well as local and state governments, and private enterprise, to generate the funds they need for expansion, development and long-term infrastructure projects.
What most people don’t realize is that the bond market in the United States is even bigger than the stock market, and that it plays a huge role in the global economy as well as in the lives of practically every American. For example, while the NYSE, NASDAQ and AMEX stock markets have an average trading volume of around $110 billion, the US Bond Market has average trading volume of almost $850 billion.
When you see a bridge being built, you can bet that bonds are what paid for it. New transportation systems that move us around, power plants that give us electricity and sewer systems that bring water to our homes and take waste away are all financed with bonds. In fact, if it wasn’t for bonds, many of the systems and infrastructure that we all take for granted would eventually break down and fall into disrepair.
So, how do Bonds work, exactly?
Bonds start when a government entity or private enterprise issues a bond in order to raise money. They are the borrower and make a legally bound promise to repay the amount of money that they borrow back to the bondholders at a specific time in the future. The amount borrowed is known as the principal or face value of the bond and the payoff date is known as the redemption or maturity date.
The best part however is that the bondholder doesn’t just get their money back, they also get interest, which is known as the coupon rate or coupon, twice a year (in most cases). In effect, the interest that is paid to the bondholder is the compensation that the government entity or private enterprise is paying in order to borrow the money they paid for their bonds.
Bonds that are issued by the United States government are usually bought directly by the investor but almost all others are purchased indirectly through broker – dealers at either banks or brokerage houses. These are known as the “underwriter” and they act as the intermediary between the issuer of the bond and the buyer/investor.
New bonds are purchased on the primary market and, if someone purchases a bond but wants to sell it before its maturity date, they can sell it on the secondary market.
Over the last few years the pricing of bonds has become much more transparent due to better industry regulation, and investors can see real bond prices on websites like www.investinginbonds.com and others. If you have any questions about purchasing bonds, or selling bonds that you already own, please let us know and we’ll get back to you with info and advice ASAP.
Filed under: Bonds
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