Bonds Payable: What They and How They Work

bonds payableA bond is a form of long-term debt. In essence, a bond is an IOU given by a company and purchased by an investor for cash. This means that the company (or corporation) is borrowing money from the investor, and it is paid back in a specific amount of time. A bond is technically a formal contract that requires the corporation to pay the amount back, along with interest to the bondholder. Every bond has a stated interest rate and the interest from the bond is paid every six months from the corporation to the bondholder. When the bond’s maturity date is up, the face amount or principal is paid.

There are many different types of investments, which you can learn more about in this investments course on Udemy. Bonds are just one type. You can also check out one of the many courses on investing for beginners available on the site to get a more thorough background of the types of investment options you have available.

Bonds are not the same as common stock. Many corporations benefit more from using bonds than stock for many reasons, which include:

  • Stockholders “own” part of the corporation whereas bondholders do not “own” part of the corporation. This means that bonds do not dilute ownership.
  • Bonds cost less than stock.

Because a bond has a formal contract, it makes it cost less than common stock. Interest is paid on the bonds every six months; the interest paid by the corporation is tax deductible on U.S. income tax returns, meaning the corporation will see a little payback for the bond whereas dividends from common stock are not tax deductible.

Bond interest rates may also change and could become less or more valuable. If a corporation agrees to pay nine percent interest on a bond over 20 years and the market interest rate rises to 10 percent, the corporation will save money. Looking at it a different way, the bondholder will lose money. Even though market interest rates fluctuate, an existing bond is locked into an interest rate at the time, called current interest.

This also goes both ways: for example, if a corporation agrees to pay nine percent interest on a bond over 20 years and the market interest rate decreases to eight percent, the corporation will lose money because they have to pay more than the current interest rate.

This is one of the main reasons people purchase bonds; no one knows what the interest rate will do, but it is a gamble that is worth the risk. Even if the current interest rises significantly, the bondholder will still receive their locked interest rate.

There are some present value calculations that can be done to determine the market value on a bond, and that can calculate the true interest rate paid by the corporation. The fixed cash payments of interest and the principal are figured in the long run to ensure that both parties get a fair trade.

There are many terms of the trade that can get confusing for some people. Take a look at the Udemy course on the bond market to get a more advanced explanation of the terms and investing strategies for bonds.

Bond Interest

To learn a little more about the interest on a bond, it is important to understand that bond interest is usually paid semiannually (every six months). The annual interest will be divided by two (one-half the annual) and paid out twice a year. The formula used for calculating semiannual interest payments includes:

Bond Amount x Annual Interest Rate x 6/12 (or ½) of a year

Bond Principal Payment

The bond principal payment is the amount that appears on the front of the bond. This amount has to be paid by the corporation to the bondholder on the date of maturity (when the bond comes due). Most of the time, the bond principal payment is due on one specific date, but there could be multiple dates.

For example, if the amount on the face of the bond was $10,000 and there were two dates: December 31, 2010 and December 31, 2015, half of the amount ($5,000) would be paid in 2010 and half would be paid in 2015.

An Example

If a person purchases a $100,000 bond that will mature in five years with a nine percent interest rate, the company will have to pay an interest rate of $4,500. Using the formula above: (100,000 x 9% x 6/12=$4,500). In this case, there would be 10 six-month time periods in five years. This means that the corporation would pay a total of $45,000 at the end of the five years, along with the $100,000 that was the initial amount of the bond.

The person who paid $100,000 would have made $45,000 extra dollars plus got his initial amount back.

It is also important to note that the corporation is only paying interest twice a year, but the interest on the bond will accrue daily. In the above example, every six months the bondholder receives $4,500. To figure the daily amount, it would be: $100,000 x 9% x 1/365, or $24.66.

This will need to be placed on the corporations’ financial statement; many corporations have multiple bonds out at one time, so these are all lumped together. Using the above example, the company would report $750 of interest expense. The formula would look like this: 100,000 x 9% x 1/12. To figure this on a calculator, you would take 100000 * 9% to receive 9,000. If you do 1 / 12, you would show 0.0833333, etc. Take the number you receive from dividing and multiply 9,000 to it to receive $750.

In essence, a bondholder can buy and sell their bonds and bond investments on any given day, so there must be a way to compensate each bondholder. The accepted technique is for the buyer of the bond to pay the seller of a bond the amount of interest that has accrued based on the date of the sale. This means if you sold your bond to someone else, they would pay you the interest due based on the sale date.

There is so much good that can happen because of a bond; it can help corporations and the people purchasing the bonds. In almost all cases, there will be interest so the bondholder will make some kind of money on their investment. There is a promise of money. You know that you will receive your money back on the bond along with a specific amount of interest.

Stocks do not offer this safety net; in many cases, the entire amount of the stock is gone. You must know how to buy low and sell high with a stock, which can be extremely difficult. Those who have worked on Wall Street all their lives still make mistakes sometimes. Therefore, bonds are a great way to invest your money and keep it safe.

No matter what type of investments you have an interest in, Udemy has a course to help you get starting earning money in investments. You can also go to Udemy now to get a full course on investment banking and get starting buying bonds.