Bonds are debt instruments that companies or governments use to raise capital. They can sell for more than face value due to factors like interest rates and market demand.
To help your friend understand bonds, you can start by explaining that bonds are debt instruments issued by companies or governments to raise capital. They are essentially IOUs that promise to repay the borrowed money, known as the principal, along with periodic interest payments.
Here's a step-by-step explanation you can use to explain bonds to your friend:
1. Begin by defining what a bond is: A bond is a fixed-income investment where an investor loans money to an entity (such as a government or corporation) for a fixed period of time at a predetermined interest rate.
2. Explain the concept of face value: The face value, also known as the par value, is the amount of money that the bond issuer promises to repay at the end of the bond's term. In this case, the face value is $5,000.
3. Discuss why bonds sell for more than their face value: Bonds can sell for more than their face value due to factors such as interest rates and market demand. When interest rates decrease, existing bonds with higher interest rates become more valuable, causing their market price to rise above the face value. Additionally, if there is high demand for a particular bond, investors may be willing to pay a premium to secure it, resulting in a price higher than the face value.
4. Give an example to illustrate this: Let's say a bond with a face value of $5,000 has an interest rate of 5%. If interest rates in the market decrease to 3%, the bond becomes more attractive because it offers a higher interest rate compared to new bonds being issued. As a result, investors may be willing to pay more than $5,000 to purchase the bond.
To summarize, bonds are debt instruments that companies or governments use to raise capital. They promise to repay the principal amount along with periodic interest payments. Bonds can sell for more than their face value due to factors like interest rates and market demand.