A bond is simply debt written in
certificates which states the amount borrowed, the interest in which the issuer
would pay the creditor and the time where the amount borrowed would be paid
back. For us individuals, borrowing money from someone is not that hard depending
on the amount asked like food money, grocery or a pack of cigarettes. It only
gets harder for us to borrow money as the amount asked gets bigger like 1 billion?
who would loan us that kind of money without digging into our financial statements
that we are actually capable of paying back the loan.
For corporations, when the sale of
stock and its own cash from operating activities isn't enough to finance a major
expansion project, it resorts to taking in debt. For instance, if a company
needed to raise 5 billion Pounds to open up bases in 20 different countries,
there is a possibility that the bank would not be able to produce that huge
amount. That's where bonds come in handy, where no single creditor is responsible
for the entire amount needed by the company. Think about this, say you need
to buy a house but because you can't get financed by banks or other financial
institutions, you would not be able to purchase the house worth say 1 million
Euros. There is another option, you got 100 relatives and friends which you
think would lend you 10,000 Euros each, but because of the amount, you need
to convince them that you can pay each one of them. Also, to raise the likelihood
that they would loan you out 10,000 Euros, you need to attract them with a high
interest rate. Issuing bonds would deliver the amount required by a corporation
or a government from a pool of investors.
In comparison, bonds are
fixed income and less riskier than stocks. Although bond returns are less than
stocks, it is a more stable capital preservation tool when greater amounts are
invested. In an event of a liquidation, creditors are paid first with the company's
remaining assets before stockholders.