Remember a few weeks ago I introduced the business of Kristi’s Ranger Cookie Food Truck? Let’s go back and visit that business to get a better understanding of how the bond market works.
As we said before, a bond is simply a loan between two parties. The buyer of the bonds is the loaner and the seller of the bonds is the borrower.
If I want to raise investor money for my food truck business without selling ownership stakes to others, I can sell bonds. Typically, a bond is sold in $1,000 increments. So, if I need $5,000, I sell 5 bonds.
The US Government pays borrows almost nothing for a short term loan. That’s because investors are guaranteed to get their money back when promised. No risk, no return.
A large corporation can’t print money like the US government, so they have to pay more interest. For example a 5-year GE bond right now yields about 1.78% interest.
My food truck business is NOT a large corporation, so buying a bond from me is much more risky than buying one from GE or the US Government. How do I incent loaners to my bonds? By paying higher interest, of course! I’d probably need to pay 5% for a 5-year bond for you to risk your money on my business venture.
So, let’s say you agree to buy my 5%, 5-year bonds for $1,000 each ($5,000 total). Every year, I’m going to pay you 5% of your $5,000 ($250) and at the end of 5 years, I’ll pay you your $5,000 back.
If I go out of business, I owe you as much of your $5,000 back as I can scrape up. That might come from selling my truck, kitchen equipment, and the rights to my amazing Ranger Cookie recipe to Giada DeLaurintis. Owners (or stockholders) get nothing in this situation.
But, If my business does amazingly well and grows by 10%/year, you only get 5% and your principal back. No more, no less.
Next week, we talk about what happens if you need your $5,000 back before 5 years is up.
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