Question

What is a bond? Who issues bonds and why? Who buys bonds and why?

Answer 1

Bonds are debt instrument where the issuer raise the desired amount and agree to pay back over a period of time along with interest for that period. Suppose $1m of the amount is raised through 1000 bonds of $1000 each for a coupon of 10% for 10 years. It means the issuer will pay 10% interest on the bond amount for 10 years and after 10 years the entire bond amount will be returned. This is one kind of the bond. There are other bonds also where repayment is done on periodic basis.

Bonds are issued by corporations, banks, governments and municipalities. There are two sources of fund any entity - equity and debt. Equity sources of fund are usually costly and not available all the time. Hence, the entities then opt for raising the fund through bonds (debt). Based on the size of the companies, cash flow of the companies and other parameters; the interest rate offered by the issuer can vary. Also, bonds provide tax benefit which reduces the cost of funding.

Bonds are purchased by financial institutions, pension funds, banks, insurance companies, other country governments (China has purchased US Govt. bonds) and retailers. Bonds provide a consistent cash flow as return and hence, becomes extremely useful for the entities who have to build portfolio where they have the visibility of cash outflow. For e.g. Pension funds would need to pay annuity for 20 years to its subscribers. Hence, the pension fund can subscribe for 20 year bond and receive the interest which in turn can be used to pay the annuity subscribers.