A bond is nothing more than an IOU. You, as the lender of funds, enter into an agreement with an "issuer" of bond securities which entitles you to periodic interest payments, or coupon payments, which will continue for an agreed up on period of time as compensation for the funds borrowed. Upon maturity (bond expiration date), the bond issuer will repay the original loan amount back to the lender.
How are Bonds Issued?
Corporate bond issuances very large in size and are sold off in one of two ways; bond issuers usually employ the help of an investment bank to take the bond to market, advertise it, and then sell it to the general public. The investment bank will bid to buy the bond security from the issuer at a discount and sell it to the open market at fair value through their sales channels. Once that security is sold, the coupon payments are made by the issuer to investor through a fiduciary agent that handles coupon payments and record keeping responsibility for the bond issuer.
For larger issuances, Investment banks work in groups, or as a "syndicate", to bid on a bond and take it to market as a team.
Another common approach issuers is to actually issue the security on their own. Typically, these issuances are smaller in size and target the retail investors who want to buy smaller sizes.
Common Bond Terminology
You may hear certain terminology being thrown around when referring to a bond. Here are a few key terms to be aware of:
The legal agreement in which the lender of funds (bond holder) gets into with the bond issuer is known as the "indenture". The indenture spells out the exact terms of the agreement between both parties for the term (1yr, 5 yr, 30yr, etc.) of the bond. The indenture will cover topics such as the dates of coupon payments (interest payments), maturity date for repayment of the bond principal, source of funds to make coupon and principal payments, and call provisions.
The indenture is a very detailed document that most investors will not read. To better summarize the details, all of the major details will be included in a document known as a "prospectus". The prospectus will be available a few days after the bond has been brought to market and it is a good idea to get your hands on it.
Bonds can easily be differentiated based on the type of entity that issued it. There are a few common types of bonds: bonds issued directly through the U.S. government are commonly referred to as Treasury bonds. Corporate bonds are then obviously bonds issued by corporations. The third major type of bond issuer are the state and local governmental agencies and these are commonly referred to as "munis" or Municipal bonds.
As we discussed above, the "underwriter" will purchase the bonds from the issuer and sell to the open market. During the next few days, the investor public purchasing the bonds are said to be doing so in the primary market. The bond holder who purchases the security may then sell that bond on the open market to another investor; this would be referred to as buying and selling in the secondary market.
Once the bond enters into the secondary market, forces of supply and demand drive the price of the bond up or down. Bond prices will fluctuate daily but upon maturity, they will be redeemed at par value.
You now have the bond basics down. The upcoming articles will dive into the bond structure and different bond varieties that exist in the market place.