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Integrity Financial Groups, Inc. > Financial Education > Bond Financing: What Is Bond Financing?

Bond Financing: What Is Bond Financing?

Bond Financing

What Is a Bond?

A bond is a fixed-income instrument used in the bond financing that represents a loan made by an investor to a borrower. A bond is typically a corporation or governmental entity. Bond financing could be thought of as an I.O.U. between the lender and borrower which includes the details of the loan and its payments. Bond financing is used by companies and municipalities for development financing and used to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond financing details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.

Bond financing is a debt instrument and represents loans made to the issuer. Corporations and governments commonly use bond financing in order to borrow money. Governments use bond financing to fund roads, schools, dams, or other infrastructure. Corporations use bond financing for real-estate, to buy property and equipment, to grow their business, to undertake profitable projects, for research and development, or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank or conventional lender can provide.

Bond financing provides a solution by allowing many individual investors to assume the role of the lender. Public debt markets let thousands of investors each lend a portion of the capital needed in the bond financing. Markets also allow lenders to sell their bonds to other investors or to buy bonds from other individuals long after the original issuing organization raised capital and provided the bond financing.

How Bond Financing Works

Bonds are commonly referred to as fixed-income securities and are one of the main asset classes that individual investors are usually familiar with, along with stocks or equities and cash equivalents.

When companies or other entities need to raise money for development financing, finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors through bond financing. The borrower (issuer) issues a bond for bond financing that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond financing principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bond financing bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

The initial price of most bonds is typically set at par, or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

Characteristics of Bond Financing

Most bonds share some common basic characteristics including:

Face value (par value) is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium of $1,090, and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.

The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.

For example, a 5% coupon rate means that bondholders will receive 5% x $1,000 face value = $50 every year.

Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.

The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.

The issue price is the price at which the bond issuer originally sells the bonds. In many cases, bonds are issued at par.

Two features of a bond—credit quality and time to maturity—are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.  

Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings. The very highest quality bonds are called “investment grade” and include debt issued by the U.S. government and very stable companies, such as many utilities.

Bonds that are not considered investment grade but are not in default are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.

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    About the author

    Dallin Hawkins brings over two decades of expertise within the finance sector, holding executive positions and distinguished as a top performer since 2003. Throughout his tenure, he has orchestrated and structured in excess of $60 billion in volume across diverse industries, including renewable energy, construction, transportation, manufacturing, mining, drilling, and oil and gas sectors. His adept negotiation skills and profound industry acumen have facilitated the successful management and funding of numerous intricate transactions. Leveraging foundational financing principles, Dallin consistently engineers structured and holistic funding solutions. His proficiency spans financial structuring, information technology, marketing, networking, and sales, underpinning his capacity to navigate multifaceted challenges with finesse. Moreover, Dallin's leadership extends beyond transactions, having personally mentored and overseen the development of countless sales executives. His guidance encompasses deal negotiation strategies, adept management of client expectations, and effective time management techniques tailored to the nuances of the finance domain. Notably, Dallin's recent financial venture stands poised to redefine and fortify the financial landscape through unparalleled growth trajectories.

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