Introduction to Bonds and Their Functions

Oct 19, 2024

Understanding Bonds

Definition of a Bond

  • A bond is a way for individuals to participate in lending to a company.
  • When you buy a bond, you become a partial lender to that company.

Example of a Company’s Financials

  • Assets: The company has $10 million in assets.
  • Liabilities: For simplicity, assume no liabilities.
  • Equity: All $10 million is owned by the owners (equity).
  • Shares: If there are 1 million shares, each share is worth $10.

Purpose of Issuing Bonds

  1. Expansion Needs: A company may want to expand and needs additional funds (e.g., $5 million for a factory).
  2. Financing Options:
    • Equity Financing:
      • Issue more shares (e.g., 500,000 shares at $10 each) to raise $5 million.
      • Result: 1.5 million shares total, increased equity by $5 million.
    • Debt Financing (Bonds):
      • Borrow from a bank, resulting in $5 million in liabilities.
      • Using this debt to acquire the factory keeps the asset side of the balance sheet identical to the equity financing.

Key Differences Between Equity and Debt Financing

  • Equity Holders:
    • Share in profits, but also share in risks.
    • More shareholders mean more people to split profits with.
  • Debt Holders (Bondholders):
    • Receive interest payments (considered an expense) before any profit distribution.
    • Interest payments are fixed and must be paid regardless of the company’s performance.
    • They do not share in the company's profits.

Issuing Bonds vs. Bank Loans

  • Instead of borrowing from one bank, a company can issue bonds to multiple investors.
  • Bonds are certificates with a face value (e.g., $1,000) and an interest rate (coupon rate).
  • For example, a bond might have:
    • 10% Annual Coupon: Paying $100 per year.
    • Maturity Date: Date when the company repays the face value (e.g., in 2 years).

Bond Issuance Example

  • To raise $5 million, the company issues 5,000 bonds at $1,000 each.
  • Buying a Bond:
    • When you buy a bond, you lend the company $1,000.
    • Interest payments (coupons) are typically paid semi-annually.

Payment Schedule for Bonds

  • For a 2-year bond with a 10% coupon:
    • Total payment: $100 per year.
    • Payments: $50 every six months.
    • Last payment includes the final $50 coupon plus the return of the principal ($1,000).

Conclusion

  • Issuing bonds is a method for companies to raise funds without giving away equity.
  • Bondholders receive fixed interest payments and principal repayment at maturity, while shareholders share in profits and risks.