Definition: A bond is a written agreement or contract between an issuer and the holder that requires the issuer to pay the holder the bond’s par value or face value plus the stated amount of interest. Bonds are most typically issued in denominations of $500 or $1,000.
What Does Bond Mean?
Typically, a bond is issued at a discount or premium depending on the market rate of interest. The bondholder pays the face value of the bond to the bond issuer. The bond is then paid back to the bondholder at maturity with monthly, semi-annual, or annual interest payments.
Companies, non-profit organizations, and government municipalities use bonds to raise funds for current operations and expansions. Since companies have several ways to finance expansions, they tend to use bond financing less regularly than government municipalities. Companies can raise funds through equity financing and traditional loans.
Bond financing has three major advantages for companies. The first and most important advantage of bond financing is that bonds don’t affect the ownership of the company unlike equity financing. Bonds can be issued without diluting current stockholders ownership shares.
Secondly, bond interest expense is tax deductible. Even though the company is incurring interest expenses to finance its bonds, the interest is tax deductible. Equity financing does not provide any tax advantages.
Thirdly, bond financing can increase return on equity. This concept is often called financial leverage. If the bond interest expense is less than the return on the proceeds from the bond, the company is actually making money by issuing the bonds. In other words, if companies can invest the bond proceeds at a higher interest rate than the bond interest rate, the company will have successfully leveraged its bond.
Municipalities traditionally issue bonds for all fixed asset expansion because they cannot pay for buildings and capital assets with income from operations.