A bond is a contract which “binds” the lender to the debtor, where an individual investor is generally the lender and the debtor is the company or government which has borrowed funds.
When a company or government entity needs more capital, whether to fund operations or a specific project, it can borrow money from investors instead of from a banking institution.
Where there is a risk of the investor not being repaid, the interest rate will be proportionally higher. The simplest way a bond works is with set payments at set intervals that gradually repay the debt and interest owed to the investor over a set amount of time.
In essence, a bond is a loan you make to a corporation, city, state, or federal government, or other entity for a specific period of time. In return, the borrower promises you two things: to pay you annual interest for the duration of the loan, and return the principal at the expiration date of the loan.
The idea behind issuing a bond is to generate more profit on the money borrowed than spent on interest paid to the bond holders (this is called leveraging). The more a corporation can leverage itself, the more profitable it becomes.
The danger here, as we found out recently during the crisis of 2008, is to keep the right balance between the amount of money you have to pay on the loans and the amount of profit you can generate. An inspection of a company’s books should include considerations of debt ratios for this reason.
Corporations usually prefer to sell bonds because their obligations are clearly specified and limited: they must pay the interest for a fixed period of time, and return the principal at the date of maturity, versus selling common shares, whereby the profits to the buyer of common shares are guaranteed forever (stocks don't have a maturity date).
To learn more about shareholder rights, see “What Rights Does Owning Shares of a Corporation Give You?”
The percentage of annual interest is known as the coupon. The date on which you will get your initial loan amount back is called the bond's maturity date. Of course, there are millions of bonds out there, including corporate, municipal, state, and federal government, and they have different coupons and maturity dates.
Usually, bonds are sold at the denomination of $1,000 per bond, and pay interest semi-annually. For example, if you buy a $1,000 bond from company ABC with a 5% coupon, you will receive $50.00 annually ($25 twice a year) until the maturity date, at which point you will get the $1,000 back (provided ABC does not go bankrupt). To learn more about bankruptcy consequences, see “What Happens When a Company Goes Bankrupt?”
Is There Anything Else I Need to Know About Bonds?
What Percentage and What Kind of Bonds Should I Have in My Portfolio?
What Types of Bonds Are There?