In finance, a bond is a type of debt security in which an issuer (typically a government, municipality, or corporation) borrows money from investors and promises to pay back the principal amount (the face value of the bond) at a specified date in the future (the maturity date), along with periodic interest payments (called coupons) over the life of the bond. Bonds are often considered relatively safe investments, especially government bonds, because they offer predictable returns. However, they also carry risks, such as interest rate risk and credit risk.
Key Features
- Face Value (Par Value): This is the amount the bond issuer agrees to pay the bondholder when the bond matures. Typically, bonds are issued in denominations of $1,000 or $100, but the amount can vary.
- Coupon Rate: The bond’s coupon rate (also called the nominal yield or interest rate) is the percentage of the face value that the issuer will pay the bondholder as periodic interest payments. The coupon rate is fixed at the time the bond is issued.
- Example: A bond with a $1,000 face value and a 5% coupon rate will pay $50 annually in interest (5% of $1,000).
- Coupon Payments: These are the periodic interest payments made to the bondholder. They are typically paid annually or semi-annually, but the frequency can vary.
- Maturity Date: This is the date when the issuer is required to repay the bond’s face value to the bondholder. The length of time until maturity varies and can range from a few months to several decades.
- Issuer: The entity that issues the bond. This could be:
- Government (e.g., U.S. Treasury bonds)
- Corporations (e.g., corporate bonds)
- Municipalities (e.g., municipal bonds)
- Price: The price of a bond can fluctuate on the secondary market, depending on various factors like interest rates, credit rating, and market demand. The price of a bond can be above or below its face value. If a bond is priced above its face value, it’s said to be trading at a premium. If it’s priced below its face value, it’s trading at a discount.
- Yield: The yield is the return an investor can expect to earn if the bond is held until maturity. There are different types of yield measures, such as:
- Current Yield: The bond’s annual coupon payment divided by its current market price.
- Yield to Maturity (YTM): The total return an investor would receive if the bond is held until maturity, considering both the coupon payments and any capital gain or loss (i.e., if the bond is purchased at a premium or discount).
- Yield to Call (YTC): The yield if the bond is called (redeemed) before its maturity date.
Types of Bonds
Bonds come in various types, depending on the issuer and other characteristics:
- Government Bonds:
- Treasury Bonds (T-bonds): Issued by the U.S. government with maturities of 10 years or more. They are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government.
- Treasury Notes (T-notes): Issued by the U.S. government with maturities between 1 and 10 years.
- Municipal Bonds (Munis): Issued by states, cities, or other local government entities. These bonds are often tax-exempt at the federal level, and sometimes at the state and local levels as well, making them attractive to investors in high tax brackets.
- Corporate Bonds: Issued by companies to raise capital. These bonds usually offer higher yields than government bonds but also carry a higher risk of default, depending on the creditworthiness of the issuing company.
- Zero-Coupon Bonds: These bonds don’t make periodic interest payments. Instead, they are issued at a deep discount to their face value, and the bondholder receives the face value when the bond matures. The difference between the purchase price and the face value represents the bond’s interest.
- Convertible Bonds: Corporate bonds that can be converted into a specified number of the company’s common shares. These bonds typically offer lower interest rates but provide the potential for capital appreciation if the company’s stock price increases.
- Callable Bonds: Bonds that can be redeemed by the issuer before their maturity date, usually at a premium. Issuers may choose to call bonds if interest rates fall, allowing them to refinance at lower rates.
- High-Yield Bonds (Junk Bonds): These are bonds issued by companies with lower credit ratings (below BBB-). They offer higher yields to compensate investors for the increased risk of default.
How Bonds Work
- Buying a Bond: When you buy a bond, you’re essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity. For example, if you buy a $1,000 bond with a 5% coupon rate and a 10-year maturity, the issuer will pay you $50 annually for 10 years, and at the end of the 10 years, you’ll receive your $1,000 principal back.
- Market Price: The price of a bond can fluctuate in the market due to interest rate changes, changes in credit ratings, or changes in market sentiment. For instance, when interest rates rise, the price of existing bonds tends to fall, because newer bonds issued at the higher interest rates become more attractive.
Valuation
The value of a bond is determined by the present value of its future cash flows, which include both the coupon payments and the face value to be paid at maturity. The formula for the price of a bond can be written as:
$$Bond\;Price=\sum_{}^{}\left( \frac{C}{\left( 1+r \right)^{t}} \right)+\frac{F}{\left( 1+r \right)^{n}}$$
Where:
- C = Coupon payment
- r = Discount rate (or market interest rate)
- t = Period of time for each coupon payment
- F = Face value of the bond
- n = Total number of periods until maturity
This formula discounts both the periodic coupon payments and the lump sum face value back to the present using the market interest rate or yield.
Risks
While bonds are generally considered safer investments compared to stocks, they still carry several risks:
- Interest Rate Risk: If interest rates rise, the price of existing bonds typically falls, because newer bonds will offer higher interest rates, making older bonds less attractive.
- Credit Risk: This is the risk that the bond issuer will default on its payments or be unable to repay the principal amount. This is especially relevant for corporate bonds or lower-rated government bonds.
- Inflation Risk: Inflation erodes the purchasing power of fixed interest payments, meaning the real value of the bond’s coupon payments decreases if inflation rises significantly.
- Reinvestment Risk: If interest rates fall, investors may not be able to reinvest coupon payments at the same rate, resulting in lower returns.
- Liquidity Risk: Some bonds, especially those from smaller issuers or with lower ratings, may be harder to sell quickly without incurring a loss.
Conclusion
Bonds are a popular form of investment because they provide a predictable income stream and are generally considered safer than stocks. They offer a way for governments and companies to raise capital, while providing investors with an opportunity to earn regular interest payments. However, they come with risks such as interest rate risk, credit risk, and inflation risk, which investors should carefully consider when investing in bonds.
Summary
- Issued By: Corporates, Governments
- Issued To: Public, Family, Private Placement
- Type of Security: Fixed Interest / Fixed Income / Debt Securities
- Duration: Medium – Long Term (> 1 Year)
- Source: Direct
- Market: Capital
- Return: Periodic (Coupon)
- Principle: On Maturity
- Liquidity: High
- Risk Level: Low
- Key Terms:
-
- Par Value (Face Value)
- Bond Indenture (Contract)
- Variations:
-
- Asset Backed Bonds
- Bulldog Bonds
- Callable Bonds
- Catastrophe Bonds
- Convertible Bonds
- Domestic Bonds
- Equipment Obligation Bonds
- Euro Bonds
- Floating Rate Bonds
- Indexed Bonds
- International Bonds
- Inverse Floating Bonds
- Junk Bonds
- Non Callable Bonds
- Original Issue Discount Bonds
- Puttable Bonds
- Samurai Bonds
- Serial Bonds
- Yankee Bonds
- Zero Coupon Bonds
Notes
- If interest rates increase, the value of the bond goes down.
- If interest rates decrease, the value of the bond goes up.
Formula
Variables
\begin{align}
C & = periodic\;fixed\;coupon\;payment \\
i & = current\;yield \\
n & = number\;of\;periods \\
A & = principal\;(face\;value) \\
k & = fraction\;of\;lapsed\;time\;between\;coupon\;payments \\
\end{align}
(a) Present Value (Bond)
$$ PV_{(Bond)} = PV_{(Coupon\;Stream)} + PV_{(Face\;Value)} $$
(b) Present Value (Coupon Stream)
$$ PV_{(Coupon\;Stream)} = C \left[ {1-({1+i)^{-n}}\over i} \right] $$
(c) Present Value (Face Value)
$$ PV_{(Face\;Value)} = A(1+i)^{-n} $$
(d) Present Value (At Coupon Date)
$$ PV_{(At\;Coupon\;Date)} = \left\{ C \left[ {1-({1+i)^{-n}}\over i} \right]+A(1+i)^{-n} \right\} $$
(e) Present Value (Between Coupon Dates)
$$ PV_{(Between\;Coupon\;Dates)} = \left\{ C \left[ {1-({1+i)^{-n}}\over i} \right]+A(1+i)^{-n} \right\} (1+i)^k$$
