BLOCKCHAIN-BASED BONDS AND HOW THEY WORK
Understanding Traditional Bond Mechanics
The global discussions about Blockchain Bonds have continued to take center stage in the world's economic banter; hence understanding how blockchain bonds work requires looking first at traditional bonds' mechanics. Understanding how traditional bonds work remains pivotal to understanding digital bonds' functions and processes.
HOW DO TRADITIONAL BONDS WORK?
Let's start with a story of you and your friend, Damon. Imagine Damon wishes to create a smoothie stand but doesn't have enough money. Damon then meets you, asking that you help him by lending him some cash, promising to pay it back at a future date with a little extra as appreciation for helping. Let's call this extra money that will be given the interest.
The explanation above applies to traditional bonds as they function the same way. This time, instead of a smoothie shop, it involves more prominent organizations like the government, institutions such as banks or pensions funds or companies.
· Issuing Traditional Bonds
From the above illustration, let's say the government of the United States wishes to build a global museum where every culture is represented and decides to borrow money by issuing bonds. These bonds are like little loan requests from the government to investors and institutions worldwide willing to invest. The government that needs the loan thereby creating the bonds, is called the issuer.
· Terms and Conditions (T&Cs)
The terms and conditions of traditional bonds outline the specific details of the bond, including Coupon rates, maturity date, and coupon payment frequency. The rates and frequency can be fixed, floating, or variable, as the case may be. Hence, you can understand all information about the U.S. bond by looking at the terms and conditions.
· Bond Indenture
Bond indentures are legal contract documentation containing all the terms and conditions of the bond. They spell out the issuers' obligations to investors/bondholders and vice versa. They also contain procedures for interest payments and principal repayment. Since all information about the bond is usually spelled out in black and white, it becomes essential to read and understand all executory documents before investing, as they can be risky, especially bonds with low credit ratings. The bond indenture is the most critical piece of documentation as it is crucial for ensuring the bond's legitimacy and the protection of investors' rights.
Most times, because of lengthy documentation and filings, lending can be a little stressful. Also, getting benefits might take longer because of verification and the rigorous administrative processes associated with traditional bonds.
· Underwriting of Bonds
Before bonds are made public for purchase, they undergo underwriting. The process is carried out by institutions called underwriters, which are often investment banks. These institutions assess the creditworthiness of these bond issuers, then help to determine the appropriate interest rate for the bonds properly. In several cases, these investment banks profit off these bonds by purchasing them from the issuer, then reselling them to investors at a slightly higher price.
· Buying The Bonds (Distribution to Investors)
Once the bonds are underwritten, you and any other entity willing to invest can purchase these bonds. Per our example with the U.S. government, what it means is that you're lending money to the U.S. government. In return for the benevolence, at a future given date, they pay back the money lent (otherwise called the capital) and compensate you for the loan with extra cash (also called interest or coupons).
· Bond Interest Payment or Coupon Payment
The bond issuer, the U.S. government, owes you and other investors a duty of paying back the loaned amount, but most importantly, paying periodic interest called bond coupons. These coupons depend on the nature of the bond agreement entered, as it can be bi-annual, annual or monthly as the case may be. Generally, interests are entitled rewards given to investors for lending to them.
· Bond Maturity Date
The bond maturity date is the bond's expiration, which could last for years, decades, or centuries in cases where they are lifetime bonds. It's at this stage (Bond Maturity Stage) that your capital is returned.
· Bonds Secondary Market Trading
Although bonds can be illiquid, they can still be traded on the secondary market. Investors can buy and sell bonds before their maturity date. The secondary market option is an exit liquidity option for investors willing to quit their investments earlier. Based on several conditions, including changes in interest rates, and the issuer's creditworthiness, the traditional bond secondary market can suffer severe fluctuations.
JOIN THE BLOCKCHAIN BOND TECHNOLOGICAL REVOLUTION
The blockchain enhances the narrative of traditional bonds by introducing technologically sophisticated techniques and automation. To understand the blockchain bond mechanics, click here.
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