When you make an investment in a company, you help to finance the growth of that company. This happens in two different ways: You can buy partial ownership in the company by buying stock, or you can give the company a loan by buying a bond. A bond issue is the process by which a company creates bonds and borrows money from investors.
A Bond Is a Loan
Bonds are a loan. That is, a bond is an agreement between a corporation or government entity -- the issuer -- and a lender or investor. The investor buys the bond for a set dollar value, known as the principal. The issuer agrees to pay back that principal by a given point in time -- the maturity date. In exchange for the right to use your money, the issuer also agrees to pay you interest.
Mechanics of a Bond Issue
A bond issue begins when a company decides it needs to borrow money from the public in order to finance its operations. Some bonds are issued for specific projects, while others provide basic working capital. The company determines how much it would like to borrow and for how long. It decides whether or not to pay interest during the life of the bond or to pay it all at once on the maturity date. It also determines what rate of interest it will pay, a figure based on the current Federal Reserve interest rate and its own credit rating. The company's lawyer draws up the legal bond agreement, often referred to as the prospectus, and makes this agreement available to potential purchasers. On a set date, known as the issue date, bond shares are made available to the public for purchase. This entire process is overseen by financial regulators to ensure it complies with all applicable laws.
Anatomy of a Bond
Every bond contains certain important information. It has a par or face value, a dollar value equal to the amount of principal borrowed. It has an interest rate and a payment schedule. Most issuers make interest payments twice per year, semiannually, but they may choose another schedule, or hold all interest until the maturity date. If they hold the interest, the bond is known as a "zero coupon" bond. The bond has a maturity date -- the date when all the principle is paid back -- and may also have a call date. Call dates are points when the issuer may pay back the bond early. Once the bond has matured -- the principle is paid off in full -- the agreement is over and the bond is worthless.
If you purchase a bond on the issue date from the issuer, the price of the bond is equal to the par value. Once you've purchased the bond, however, you may sell the debt to someone else, a transaction that's known as the secondary market. Bonds on the secondary market often sell at slightly more or less than their par values, depending on what has happened to interest rates since the bond was issued. If interest rates have gone up, buyers will pay less for the bond, since they could get more interest elsewhere. If rates have gone down, buyers will pay a premium to get more interest over the long term.