“What exactly is a bond?”
“What is the difference between government bonds and corporate bonds?”
“When I buy a bond, who am I lending money to?”
“What are interest rates and maturity?”
When you start investing, you will see various terms like
stocks
investment trusts
ETFs
bonds
government bonds
and so on.
Among these, bonds are a financial product that many people have heard of, but
“I don’t really understand how they actually work”
is a common sentiment.
To put it very simply, a bond is
“Please lend me money. In return, I will pay a set interest rate and repay the principal when the term expires.” in the form of a promise.
If a country uses this mechanism, it is a government bond, and if a company uses it, it is a corporate bond—that is the general idea.
In this article, we will:
Explain what a bond is in the first place
Explain why countries and companies issue bonds
Explain the difference between government and corporate bonds
Explain what face value, interest rate, and maturity mean
and look at the mechanics of bonds themselves for beginners, step by step.
What are bonds?
A bond is something issued by a government, company, or similar entity to borrow money from investors.
The party that issues bonds to borrow money is called an issuer.
For example,
if the Japanese government issues a bond, the Japanese government is the issuer.
If a company issues a bond, that company becomes the issuer.
And the investor who purchased that bond is effectively lending money to the issuer.
Simply put:
Buy a government bond
→ Lend money to the government
Buy a corporate bond
→ Lend money to a company
is the general idea.
Why does the “bond” mechanism exist?
Countries and companies sometimes need a large amount of money to carry out their activities.
Governments have various expenditures, such as social security, public works, and administrative services.
And, government bonds are issued as one way to raise funds that cannot be covered by tax revenue alone.
For a company,
・Building factories or facilities
・Starting new businesses
・Acquiring companies
・Conducting research and development
・Securing funds necessary for business operations
they may sometimes need a large sum of money for purposes such as these.
However, it is not always possible to provide all the necessary funds from cash on hand.
Therefore, “collecting funds from people who will lend money” is one method where bonds are used.
In other words, bonds are a mechanism for governments or companies to borrow money.
How is it different from borrowing from a bank?
One way for a company to borrow money is to borrow from a bank.
When borrowing money from a bank, basically,
the lending and borrowing of money takes place between the company and the bank.
On the other hand,
when issuing bonds, funds are collected from investors who underwrite the bonds.
To summarize simply,
Bank borrowing
→ Borrowing mainly from banks, etc.
Bond issuance
→ Collecting funds from investors who underwrite the bonds, etc.
This is the difference.
It is not a matter of which is better; companies use various methods depending on the reason they need funds, their financial situation, and so on.
How are stocks and bonds different?
Both stocks and bonds are sometimes used by companies to raise funds.
However, the mechanisms are significantly different.
People who purchase stocks become shareholders. In other words, they are in a position of investing in the company.
That is, they are in a position to invest in the company.
On the other hand, people who purchase bonds issued by a company are in a position of lending money to the company.
To put it simply,
Stocks
→ Investing in a company
Bonds
→ Lending money to a company, etc.
is the difference.
Also, stocks usually do not have a maturity date, such as “we will return the money in X years.”
On the other hand, bonds often have a set maturity date.
What kind of promises are made when issuing bonds?
Bonds are not just about saying “please lend me money.”
When issuing them, the conditions under which the money is borrowed are determined.
Typical examples include
・Face value
・Interest rate
・Interest payment date
・Maturity
, etc.
For example, suppose a company issues a bond with a
face value of 1 million yen
, an interest rate of 3% per year
, and a maturity of 5 years
.
To put it very simply, the company is essentially promising,
“Please lend me 1 million yen. I will pay 3% interest per year and return it in 5 years.”.
Investors look at those conditions and consider whether to purchase the bond.
This is the basic mechanism of bonds.
What is face value?
Face value is the base amount set for a bond.
For example,
if it is a bond with a face value of 1 million yen, the basic mechanism is that 1 million yen will be returned at maturity if the issuer is able to repay as planned.
This process of repayment according to the conditions set for maturity and other factors is called redemption.
Are the purchase price and the face value of a bond the same?
Not necessarily.
For example, even for a bond with a face value of 1 million yen, the price at the time of issuance is not always 1 million yen.
Also, when bonds that have already been issued are traded, their prices can fluctuate.
In other words, face value and the actual trading price are different things.
This distinction is very important when understanding bond investment.
The reasons why bond prices move will be explained in detail in the article “What is bond investment?”
What is an interest rate?
For some bonds, interest is paid based on conditions determined at the time of issuance.
The rate used to calculate that interest is the interest rate.
For example, for a bond with a face value of 1 million yen and an annual interest rate of 3%, to simplify:
The annual interest is 1 million yen × 3% = 30,000 yen .
In short, the idea is: “If you lend me 1 million yen, I will pay you 30,000 yen in interest per year.”
However, the actual frequency of interest payments and the conditions vary depending on the bond.
How many times a year is interest received?
It depends on the bond.
For example, there are cases where it is paid once a year, and cases where it is split into two payments per year.
The day interest is paid is called the interest payment date.
For instance, if a bond pays 30,000 yen in annual interest split into two payments, the simplified image is that you receive 15,000 yen each time.
Do all bonds pay interest?
When you hear the word “bond,” you might think, “I will definitely receive regular interest.”
However, not all bonds work the same way.
Some bonds do not pay regular interest; instead, they are issued at a price lower than their face value, and the difference becomes your profit when you receive the face value at maturity.
Such bonds are sometimes called discount bonds.
However, as a beginner, it is sufficient to first grasp the basic concept that
there is a type where you receive interest and the face value is returned at maturity.
What is maturity?
Maturity is the deadline for the issuer to repay the money.
For example, a 5-year maturity bond is generally redeemed 5 years after issuance.
In the previous example, it is a promise that “I will borrow money for 5 years and pay it back after 5 years.”
Bonds can have relatively short terms, or long terms such as 10, 20, or 30 years.
The period until maturity varies depending on the bond.
Do I have to hold it until maturity?
Depending on the bond, you can also sell it before maturity.
However, if you sell before maturity, you are not guaranteed to sell at the face value.
The price may fluctuate depending on market conditions at that time.
This part, “why bond prices rise and fall,” is extremely important for understanding bond investment.
We will look at this in more detail in the article “What is Bond Investment?”
What are Government Bonds?
Bonds issued by a national government are called government bonds.
Those issued by the Japanese government are Japanese Government Bonds (JGBs).
In other words, purchasing Japanese government bonds means,
simply put, lending money to the Japanese government.
The Japanese government also issues government bonds as one way to raise necessary funds.
There are various types of government bonds with different maturity periods and interest mechanisms.
What are Government Bonds for Individuals?
In Japan, there are government bonds for individuals designed to be easy for individuals to purchase.
Representative examples include
10-year floating rate, 5-year fixed rate, and 3-year fixed rate bonds.
For the 10-year floating rate bonds, the applicable interest rate is reviewed at regular intervals.
On the other hand, for 5-year and 3-year fixed rate bonds, the interest rate determined at the time of issuance generally remains the same.
Government bonds for individuals differ from government bonds traded on the general market in terms of mechanisms such as early redemption.
What are Corporate Bonds?
Bonds issued by companies are called corporate bonds.
For example, suppose a company needs 10 billion yen to build a new factory.
However, they do not have enough funds on hand.
Therefore, they may issue corporate bonds to raise funds by saying,
“Please lend us the money needed for our business. We will pay interest and repay the principal at maturity.”
When an investor purchases these corporate bonds, the company uses those funds for its business.
Then, they pay interest according to the set terms, and if they can repay as planned when the bond reaches maturity, they will repay the face value.
What are municipal bonds?
It is not just national governments that issue bonds; local governments do as well.
These are called municipal bonds.
Prefectures, cities, towns, and villages may issue them to raise the funds necessary for public facilities or infrastructure development.
Are there foreign bonds too?
Yes, there are.
There are also bonds issued by overseas countries and companies.
For example, U.S. Treasury bonds issued by the U.S. government are one of the most representative types of bonds.
There are also corporate bonds issued by foreign companies.
Since some foreign bonds are issued in currencies other than the yen, they may be affected by exchange rate fluctuations.
This point will also be explained in detail in the article “What is bond investing?”
Once a bond is issued, who holds it?
It is not just individual investors who purchase bonds.
For example,
• Banks
• Insurance companies
• Pension funds
• Investment trusts
• Overseas investors
• Individual investors
and various other investors hold bonds.
In other words, from the perspective of the issuer,
bonds are a mechanism for borrowing money from various investors as well.
Can bonds be sold to someone else after they are issued?
Some bonds can be traded between investors after they have been issued.
For example, the person who initially purchased the bond may sell it to another investor before waiting for maturity.
In this case, the money used to buy the bond is basically paid from the new investor to the investor who sold it.
The proceeds from that sale do not go to the issuer.
For example, when a company first issues corporate bonds, funds go from the investors to the company.
However, if investor A later sells the corporate bond to investor B, the sale proceeds are basically exchanged between A and B.
In short, issuing bonds to raise funds and trading issued bonds between investors are different things.
Why can the price of a bond differ from its face value?
Even though the face value to be returned at maturity is fixed for a bond, the price at which it is traded in the interim can change.
The reasons for this include
• Market interest rates
• The creditworthiness of the issuer
• The remaining time until maturity
• Market supply and demand
and so on.
Particularly important is the relationship between interest rates and bond prices.
Generally, there is a relationship where bond prices tend to fall when market interest rates rise, and bond prices tend to rise when market interest rates fall.
However, this is a part of bond investing that can be a little difficult to understand.
Regarding “why bond prices fall when interest rates rise,” I will explain it in detail using concrete examples in the “What is Bond Investing?” article.
Are interest rates and yields the same?
These are two terms that beginners often confuse.
Interest rate is
basically the percentage that indicates how much interest will be paid relative to the face value of the bond.
On the other hand, yield is
the percentage that looks at how much profit you will make relative to the amount actually invested, including interest and gains or losses from trading or redemption.
For example,
even for bonds that provide the same 30,000 yen in annual interest,
the amount invested differs if you bought it for 1 million yen versus 900,000 yen.
Therefore, the yield also changes.
At the beginner stage,
Interest rate → The percentage of interest set on the bond
Yield → The percentage that looks at how much profit you will make relative to the amount actually invested
It is easier to understand if you grasp this difference.
There are several ways to calculate yield.
For details, I will explain in the article “What is bond investment?”
Will the money always be returned with bonds?
This is important.
With bonds, the basic mechanism is that the face value is returned at maturity if the issuer can repay as scheduled.
However, it is not guaranteed that it will always be returned.
For example, there is a possibility that a company may go bankrupt and become unable to repay the borrowed money.
This situation, where an issuer becomes unable to pay interest or the face value as scheduled, is sometimes called default.
In other words, when you “lend money,” whether the other party can pay it back is also important.
With bonds, you also need to check “who you are lending money to.”
We will look at creditworthiness and bond investment risks in detail in the article “What is Bond Investment?”
Bonds have differences in creditworthiness
The possibility of being able to pay back money is not the same for every country or company.
Therefore, when looking at bonds, the creditworthiness of the issuer is also important.
One of the materials for judging creditworthiness is credit ratings.
A credit rating is an evaluation of the creditworthiness of a country, company, or similar entity by a rating agency based on certain criteria.
However, a high credit rating does not mean it is absolutely safe. It is merely one piece of information to use for judgment.
Are bonds and deposits the same?
You might feel that bonds are similar to deposits in that you “lend money and receive interest.”
However, the mechanisms are different.
Bank deposits involve depositing money into a bank.
On the other hand, bonds are a mechanism where you purchase financial products issued by countries or companies and lend money to the issuer.
Also, some bonds have prices that fluctuate during the term, so they cannot be thought of in the same way as deposits.
Basic terms to remember when understanding bonds
Let’s briefly summarize what we have covered so far.
Issuer
→ Entities such as countries or companies that issue bonds to borrow money
Face Value
→ The base amount set for a bond
Coupon Rate
→ The percentage of interest paid relative to the face value
Interest Payment Date
→ The date on which interest is paid
Maturity
→ The deadline by which the issuer must repay the money
Redemption
→ Repayment made according to specified conditions, such as at maturity
Yield
→ The percentage that indicates the actual return on the invested amount, including interest and gains or losses from trading or redemption
If you grasp these points first, it will be much easier to understand news and explanations regarding bonds.
Summary
A bond is something issued by a country, company, or similar entity to borrow money from investors.
To put it quite simply, it is a formal promise by the issuer that says, “Please lend me money. In return, I will pay a set interest rate and repay the principal when the deadline arrives.”.
Purchasing a bond means lending money to the issuer.
Bonds issued by a country are called government bonds
, and those issued by a company are called corporate bonds
.
Bonds have conditions such as
face value
, coupon rate
, interest payment date
, and maturity
determined in advance,
and the basic mechanism is that if the issuer makes payments as scheduled, you receive interest, and at maturity, the face value amount is redeemed according to the specified conditions.
However, unlike bank deposits, there is a possibility that the issuer may become unable to repay the bond.
Also, for bonds that are traded in the secondary market, their prices fluctuate depending on factors such as market interest rates.
First, if you grasp the difference that “stocks are an investment in a company, while bonds are a mechanism for lending money to countries or companies”,
it will be easier to understand how bonds work.
Next,
how to make a profit from bonds,
why bond prices fall when interest rates rise,
what kind of risks exist,
and how they differ from mutual funds and ETFs that target bonds
and other such mechanisms of bond investment will be explained in detail in another article.
