A bond is basically a contract whereby a corporation may borrow money and, in turn, promises to pay interest at a stipulated rate for a fixed period of time. While the stockholder is a part owner in the business, the bondholder is simply a creditor and as such has a prior claim upon the assets of the corporation.
In the event of failure of the issuer of the bond to carry out the provisions of the contract (commonly known as the indenture), the bondholder is protected by law and may take the necessary steps to recover the principal amount which he has lent; in practice this is done by the appointment of a trustee to act for all bondholders as a group in the event of any legal action. In case of bankruptcy, the claims of any bondholders are prior to all other claims and must be satisfied before stockholders of any class receive anything. Should more than one bond issue be involved, they are usually satisfied in the order of their rank or issue.
Bonds are classified in a number of ways. By purpose of issue we may have bridge, highway, terminal, and equipment bonds; by origin we may have railroad, utility, government, municipal, and industrial bonds; by type, referring to the bond itself and its various investment attributes, we may have coupon, registered, callable, convertible, and sinking-fund bonds.
By the character of the lien or contract they may be called secured if they are a direct mortgage upon certain assets; or unsecured if they are based entirely upon the investment repute of the issuing agent; the latter are commonly termed "debentures," and the so-called U. S. Savings Bonds are more properly debentures, since they depend entirely upon the integrity of the Federal government and are not a lien against any of its properties.
The most common denomination in which bonds are issued is that of $1000, although occasionally $500 bonds are also offered. In a few cases, such as the well-known debentures of the American Telephone & Telegraph Company, and certain railroad bonds, the $100 bond is also made available. The higher denominations are most commonly employed, because most bonds are sold to large financial institutions or to wealthy individuals in very large amounts, and the costs of printing and handling are much reduced if the large denomination is employed.
A bond is issued for a fixed period of time, commonly called the term, such as 20 years. It carries a fixed rate of interest, such as 4 percent. This stated rate and term appear as part of the contract, but the rate is essentially not the effective rate, which depends upon the price at which the bond is bought. For example, let us suppose we are dealing with a $1000 bond and a stated rate of 4 percent, which means that the bondholder will receive $40 per annum, usually in two semiannual installments of $20 each. If this bond was purchased in the open market for $900, then the true yield would be 4.4 percent, rather than that stated on the bond itself, it being quite obvious that a return of $40 on $900 must be higher than the same return on an investment of $1000. In a like manner, this bond would yield less than 4 percent if bought for more than its face (par) value.
Tables have been constructed which show the actual yield upon $100 for a wide range of purchase prices and for various stated interest rates. They are available at many banks, stockbroker offices, and public libraries.
Bonds are a safe investment in that, when purchased from a government, the government guarantees that the bondholder's money will be paid back with interest. Bonds can be good options for those looking to put some money away for a child's education or a portion of their retirement, because although the returns aren't high, they are guaranteed.