What is a Bond?

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To many, when they think of bonds, they think of what a retired person’s portfolio is made of. Safe, boring, perhaps low return.

What’s important to understand is what a bond actually is. An example:

If you need to borrow $1000 and I have $1000 and we agree that you’ll pay me $50 per year while you have my money, and in 5 years, you’ll pay me back my $1000, the contract that says you owe me is essentially a bond.

There are plenty of groups that like to borrow money. Governments, corporations, etc.. Some have more risk in their ability to pay you back than others. The risk that you might not get paid back in part or in full is called ‘credit risk’. The US government is generally considered the safest place you can lend your money to. They can of course, just print it if they need to pay you back.

However, there are companies with dubious credit who are looking to borrow money. For instance, Tesla has recently raised cash by selling bonds. Bonds under a certain rating are called ‘junk bonds’ or ‘high yield bonds’, sort of the bond world equivalent of ‘robber barons vs. captains of industry’.

Now, using Tesla as an example, you can buy a bond issued by Tesla or buy Tesla stock. What’s the difference? As we explored with stock, you are an owner and are entitled to a share of the profits. However, before profits are calculated, debt has to be paid! So if you buy Tesla bonds, and Tesla sells just enough cars to pay the bonds, but doesn’t have any profit left over after that, the bond holders will get paid, but the stockholder’s won’t have any profits to distribute or reinvest in their company. Taken to an extreme, when a company goes bankrupt, the bondholders are paid back first before the stockholders get a dime.

So yes, a bond can be very safe, very risky, Very short-term, or very long. As long as you understand the idea; that you are lending money to somebody in exchange for interest in the meantime, you understand a bond!

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