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A bond is a type of debt capital instrument that is used to generate funds for the issuer. While there are several different ways to structure a bond issue, the most common approach is to sell the debt instrument to an investor at a specific price. The investor holds the issue for an agreed-upon period of time. In exchange for granting what is essentially a loan to the issuer, the investor ultimately is repaid the full purchase price of the bond, along with an agreed upon rate of interest for that loan. Both businesses and governments utilize this type of debt capital instrument as a means of generating funds for various projects without the need of utilizing assets already in hand to manage those same projects.
Bonds may be sold at what is known at face value, or at a rate that is below the face value. When the instrument is sold at face value, the issue is ultimately redeemed at that value plus interest that is either paid incrementally throughout the life of the bond, or at the time the debt instrument reaches full maturity. Interest rates may be fixed or variable, as indicated within the terms and conditions that govern the purchase of the instrument. Issues that are sold below face value are usually redeemed at maturity at full face value, rather than issuing interest payments to the holder throughout the bond’s life.
Many different types of entities utilize bonds as a means of raising money to fund different types of projects. Municipalities, state governments, and even national governments may issue this type of debt instrument as a means of generating funds for projects that ultimately benefit citizens. For example, the money raised with a given bond issue may be used by a city to pave streets and other thoroughfares within the city limits or to improve the facilities at parks located in various neighborhoods. The funds may also be used as a way to manage the building of a new city hall, with the understanding that taxes collected over the life of the issue will be used to essentially buy back the bonds once they reach maturity, plus provide interest payments to investors.
Businesses also sometimes use bond issues as a way to generate money, rather than borrowing against other investments or selling assets to managing that funding. Here, the goal may be to use the funds to build a new plant that ultimately begins to earn a profit, or develop and market a product that eventually generates enough sales to offset the costs of that development and marketing. Along the way, companies may issue periodic interest payments to investors, with those payments often being tax-deductible for the businesses. Assuming that the project is generating profits by the bond’s maturity date, the company will not have to dig into its coffers to come up with funds to settle the bond issue and pay investors both the principal investment plus any additional funds they are due according to the structure of the issue.
A bond is similar to an I.O.U. This means your lending the government or agency money. Instead of the government or agency writing out a sticky note to you saying how much they need to pay you back, they give you a bond with a specified amount that is owed back to you.