When an institution wants to borrow money, instead of taking out a loan from a bank, it can sell bonds to investors.
A bond is a type of debt for the institution. Because when it sells you a bond, it is borrowing money from you. And it has to pay you back at a later date.
There are three primary components to a bond. The first is the Face Value. The face value is the amount of money per bond that the institution pays you back when the bond matures.
The second component is the Coupon. The coupon is the interest, or additional money, the institution pays you every year for borrowing the money.
The third component is the Maturity Date. The maturity date is the end date of the bond, and it’s when the institution pays you the face value.
Let’s walk through an example of how a bond works. Assume you want to buy a new bond with a $1,000 face value and 5% coupon that matures in 10 years.
First, you purchase the bond from the Issuer. The amount of money you give the Issuer to pay for the bond is called the Principal Amount. When the principal amount is equal to the bond’s face value, it’s called a Par Bond.
For the next 10 years, you get paid interest of 5% of the bond’s face value, which is $50. That means every year you get $50 in coupon payments from the Issuer. For a total of $500 coupon payments.
At the maturity date of 10 years, your bond investment ends and the Issuer pays you the face value of $1,000.
Remember, when you buy a bond you are lending the institution money. So buy bonds from institutions you believe will succeed!