THE CAPITAL MARKET
How do bonds work?
Bondholders effectively buy a slice
of a larger loan with each bond, for
which they receive interest, along
with the original sum on maturity.
Issuing, buying, and selling
bonds takes place in the debt
capital market. The marketplace
has several functions: it offers
bonds and other types of loans to
investors; it operates as a fixed-
income market, because the issuer
is required to pay regular interest;
and it enables companies and
governments to raise long-term
funds. Overall, the debt capital
market is much larger than the
stock exchange (equity capital
market), where shares are bought
and sold. It attracts investors
because bonds provide more
protection from risk than shares.
There are various types of bonds,
some safer than others—the risk
lies in whether the issuer will be
able to pay the interest and repay
the principal sum on maturity. A
secured bond is backed by an asset,
such as property; an unsecured
bond is not and so carries more risk.
Both bonds and shares may be
referred to as securities. The term
describes the share or bond itself,
and the certificate of ownership or
creditorship that gives the holder
the right to receive a dividend,
in the case of shares, or interest
payments, in the case of bonds.
BOND
$100
BOND
$100
$100
Company issues bonds
The company issues 1 million bonds at $100 each.
Each bond effectively acts as a loan between the
investor and the company.
Investors buy bonds
Each bond has a set maturity date of 10 years and
a 7 percent interest rate, with a face value of $100.
During the 10 years, the company can use the
money as capital.
Investing in the debt capital market
A company wants to raise $100 million to finance growth but does not wish to
issue further shares. Instead, it raises the money by issuing bonds on the debt
capital market.
NEED TO KNOW
Debt instrument Official term
for bond or other long-term debt
Convertible bond Bond that
can be converted into shares of
the issuing company, or cash
Warrant Security that allows
the holder to buy stock in a
company at a fixed price
Callable bond Bond that
gives the issuer the right to
redeem it before maturity
Non-callable bond Bond
that has no maturity and cannot
be redeemed or sold back to
the issuer, but continues to
provide interest
10 YEARS
7%
interest
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how finance works
Raising financing
Secured
Government bonds are the safest
type of bond since governments
in developed capitalist economies
are unlikely to default on interest
payments on the loan or on the
principal sum.
Secured bonds are secured by the
assets of a company, making them
a less risky investment than shares.
Examples include equipment, trust
certificates, and mortgage bonds.
Unsecured bonds are not
backed by pledged collateral and are
a riskier investment—if the company
fails, investors are paid only after
secured bonds have been paid
out. Because they are more risky,
investors expect a higher return
(interest) on their investment.
Types of bonds
GOVERNMENT
BONDS
SECURED BONDS UNSECURED BONDS
Unsecured
10 YEARS
$100
$7
Investors receive annual interest
Each year, the company pays an investor $7
(7 percent of $100) for each bond bought, in
return for using the principal sum as capital to
fund its business. After 10 years, the investor has
received a total of $70 interest per bond.
Mature bond is repaid
Once the bond reaches its date of maturity, in this
case 10 years, the original sum of money, $100, is
repaid to the investor. So the investor receives a
total of $170, including interest, over the full term,
in return for the original $100 investment.
Secured
Corporate bondsGovernment bonds
0
5 10
YEARS
INTEREST PAID (%)
100
90
80
70
60
50
40
30
20
10
1 2 3 4 6 7 8 9
$70
over 10
years
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