DEFINITION: A “bond” is a type of negotiable instrument known as a “tradable financial asset” or “security” (a “financial asset” is a non-tangible asset based on a contractual claim).
A bond is a security which establishes a debt between its seller (the “issuer”) and its purchaser (the “holder”) with the following conditions:
- The issuer must repay the principal to the holder by a set date (the “maturity date”).
- The issuer must also pay interest in predetermined amounts (called “coupons”) at fixed intervals.
Thus, a bond is an IOU—that is, a loan—by means of which the bondholder lends money to the bond issuer for a specified period of time.
ETYMOLOGY: “Bond” derives from the Middle English word band, meaning “band” or “fetter,” which is itself of Old Norse origin. Thus, a bond is an instrument that binds the issuer to repay the bondholder.
USAGE: Bonds are issued by both corporations and governmental entities, whether at the municipal, county, state, or federal level.
Bonds may be issued for the purpose of raising capital to finance long-term investment, special projects, or current expenditure.
Since bonds are essentially securities—that is, tradable financial assets—there are primary and secondary markets devoted to trading them. Seeing that bonds may be traded on the secondary market at prices higher than the principal amount, it is necessary to distinguish a bond’s face value from its “valuation.”
Both stocks and bonds are securities. The difference between them is that a stock establishes an equity stake in the issuer, whereas a bond establishes a creditor stake in the issuer.
Since secured creditors have legal priority over owners, in the event of bankruptcy an issuer’s bonds will be repaid before its stocks.
Another difference between stocks and bonds is that bonds usually have a defined term (the maturity date), whereas stocks normally have no such time limit. However, there is an exception to this rule. Namely, an “irredeemable bond” resembles a stock in lacking a maturity date.
Finally, bonds closely resemble certificates of deposit (CDs) issued by banks. The main difference between the two instruments is that CDs typically have a shorter term.