As stated previously, purchasing a corporate bond is equivalent to lending money to a company. Just like banks granting a loan to a company, a bond purchaser expects to receive a proper fee for the use of his funds. The fee depends on the duration of the loan and the bond purchaser’s estimation of the risk involved in lending the company his money (meaning his estimation of the probability that he will be repaid). Bondholders usually expect a larger return from the company than might otherwise be obtained from a bank deposit.
A firm can borrow money from the public only through the capital market.
If a firm wants to borrow one million dollars for two years and agrees to pay 10% interest, it prepares bond certificates in advance. Each bond is usually issued with a face value of $1,000. Investors receive a certificate for each $1,000 loaned. Companies often offer the public a discount, so investors often pay less than $1,000 for a similar $1,000 loan that is granted to a company.
The firm redeems all of its certificates after two years. It pays $1,000 per certificate, regardless of how much the investor paid. If investor A loaned the company $10,000 for two years and received 10 certificates, each with a face value of $1,000, the company will pay the investor as follows for each certificate:
Calculating the Return of $1,000 Debt to a company
End of 1st year
End of 2nd year
At the end of the second year, the bonds “mature”, and the principal is repaid.
Bondholders are entitled to sell their bonds at any time and to whomever they choose. The borrowing firm is obligated to pay interest and principal value on the dates stated in the bond, to anyone in possession of the bonds at those times.
Receiving a bond certificate in return for lending money to a company is called “buying bonds” even though the bond purchaser is actually making a loan.
A bond certificate is an asset like any other, and can be bought and sold on the stock exchange the same way that stocks are bought and sold. All transactions involving bonds are referred to as either buying or selling. Bonds are traded on the market daily in the same way that stocks are traded.