By Kai Luginbuhl –  Director of Finance 

The bond market is one of the largest financial markets in the world, larger than the stock market (Morningstar). However, despite its size, the bond market does not get attention like crypto or equities, so today, we’ll provide some basic information on it.

A stock is buying a piece of a company and technically owning it. However, a bond is simply lending money in exchange for interest payments. There are many different types of bonds, but let’s use a very common example of a one-year bond that pays a “coupon.” If Ford Motor Company needed extra cash to fund a project, they could offer standard $100 face value bonds to the public. Therefore, if you bought one, you’d be lending $100 to Ford for a year. Throughout the year, Ford would pay you interest payments (to thank you for lending them money), and then, after 365 days, Ford would give you $100 back. This has many variations, but the essential concept is similar across the bond industry.

Bonds are considered safer than stocks because you know your future payments and that you’ll get your cash back, unlike a stock where you could buy $100 of it one day and have $30 the next. However, there are varying degrees of risk. Let’s go back to our Ford example; if you lend $100 to Ford in exchange for a $3 (three per cent) interest payment, and suddenly a scandal comes out where Ford goes bankrupt, you may not get your $100 back (if they don’t have $100 to give). Before lending your money, you will want to know how trustworthy they are. I’ll explain the letter notation system here, but I promise it’s not anything complicated. Companies get rated from “AAA” to “D” (S&P) based on their trustworthiness with your money. “AAA” is reserved for governments and companies considered the safest of safe investments. As you go down the rating levels, the chance of losing your money gets higher (theoretically).

Generally, the more risk you’re willing to take, the more a company will pay you for lending them money. You’re welcome to look up bond offerings online and see that a non-trustworthy company will pay you handsomely for taking a risk on them, whereas a government or bank will give you much less. Imagine this concept as if your friend with a good job asked to borrow $100; you’d probably give it to them with their promise of paying you back and buying you a coffee for your troubles. Now, imagine someone you aren’t very close with, who doesn’t have a job, asking for $100; the mere payment of a coffee is not worth never getting your money back. So, they would have to offer you something more substantial to attract you. This relationship of risk to reward is what drives the bond market.

There are many variations and caveats in the bond industry, and it goes much, much more in-depth than what’s explained above. However, this is meant to shed some light on the bond market and inspire students to do their own research. The bond market offers some of the safest investments you can find; just be careful who you lend your money to because you may not get it back.

Kai is the president of the BU Investment Club. The information provided in this article is for educational purposes only and should not be taken as financial advice.