What is a bond and how does it differ from a loan?
In: Economics
It’s VERY similar. From the borrower’s point of view a bond and a loan are both means to get money now and pay that money back, plus interest at a later date.
Historicly bonds were more tradable and sellable but in the past 20-25 years loans have become things that also get bought and sold. But technically speaking that’s the main difference.
A bond is issued by the company (borrower) and bought by the lender. The terms are set by the company and the lender eauther purchases the bond or does not. The bond can then be resold and traded without the permission of the original lender.
Where’s a loan is more like a contract to borrow money between 2 parties (the borrower and the lender). In modern times the lender can sell that contract but that’s a relatively new invention and normally needs to be specified within the contract that they have this right. Loans often have a lot of details in terms of milestones, that the company might need to maintain (called covenants) that are generally not present in a bond.
It’s also worth pointing out. Non-publicly listed companies can’t generally sell bonds because they don’t adhere to the same set of rules as public companies do in terms of disclosure and whatnot. But anyone can take out a loan as long as a lender is willing.
A bond has a fixed repayment schedule in which only interest is paid for the term on the bond. Then, when the bond comes due, the debtor has to repay the face value of the bond in one lump sum.
So, imagine you buy a 10 year bond with a 10% interest rate, paid once per year. This bond cost you $100. You will be paid $10 per year, each year for 10 years. At the end of year 10, you will be paid one final payment of $110 – the $10 in interest you were owed plus the $100 you initially paid for the bond.
That payment structure is pretty much fixed with a bond – every bond will have a face value that was initially paid for it, an interest rate, a frequency of interest payments, and a maturity date on which the final payment is owed. The debtor also can’t speed up the payments unless the bondholder consents. So, using the above example, the debtor can’t make a $20 interest payment one year to reduce the amount of interest they owe in subsequent years.
A loan has a more open ended payment schedule that, in theory, never has to be paid off. All a loan requires is that you pay interest on the remaining balance of the loan at a specified frequency. If you want to pay more you can, which will reduce your future interest payments. Some loans also let you pay less, in which case the balance of the loan simply increases.
So, imagine that you loan someone $100 with a single 10% interest payment each year. Each year your borrower just needs to pay you $10 to be current on the loan. If they want to pay you $10 per year for the rest of eternity, they are entitled to do that. But the debtor can also choose to pay you $70 at the end of year 1. This covers the $10 in interest that they owe, as well as $60 of the loan’s original balance, reducing it from $100 to $40. Now they only owe you interest on that remaining $40 at the end of year two – which would be $4.
Because loans are more open ended, they will sometimes contain provisions that allow you to be considered current even though you aren’t making payments on them. They also will sometime contain provisions that allow the lender to “call” the loan, which forces the debtor to pay back the entire principle balance at once.
Most consumer loans have what’s called an amortization schedule, which is a schedule of fixed payments that will result in the loan being paid off over a certain amount of time.
A bond is basically a securitized loan, meaning it’s created and something sold to investors. This means it can be bought and sold from investor to investor.
Bonds are also sold to many parties, vs. a loan that’s typically a single lender. Instead of applying to a bank for a single $10m loan, a bond issuance could get sold off to 10,000 investors in $1000 increments.
And in terms of repayments, bonds pay interest according to the terms (eg. 5% for 10 years) and then return the principal at the end o the term vs. a loan that’s a combination of interest and principal during payments.
Bond: One borrower (typically company or government) raises money from many lenders, who buy the bond as an investment.
Loan: One borrower borrows money from one lender, who lends money in the normal course of business (e.g. a bank).
It is not different, in the sense that it is a **kind** of loan.
A loan is any agreement where I give you something (usually money) and you promise to give it back (in the case of money, usually with “interest,” which is my profit on the transaction). We might also set a time period for that pay-back, and that’s called the “term” for the loan.
If I am concerned you might not pay back the loan, I might insist that it be backed by some kind of security or collateral. For instance, you might agree that if you don’t pay back your loan on time, you have to give me your car instead.
The details of bonds vary but they should have all three of those elements for the loan — an interest rate, a term, and a security or collateral. In general, a bond is a loan of money upfront, with the promise that you will pay it back at the end of the term, pay me interest each year in the meantime, and if you go bankrupt before you’ve paid me back, I get a place near the front of the line for any of the assets you have left that can be sold off to settle your debts. This means that if the company collapses, there’s still a chance I’ll get some of my money back.
This last part matters in an investment context because it is in direct contrast to the people who own shares or equities (“stock” in the company). In the event of bankruptcy, the shareholders usually get put last in line, which means that by the time it’s their turn for a share of the remaining assets, there are almost never any assets left. When the company goes bankrupt, they get wiped out.
Latest Answers