I’m gonna explain to you, the basic concept of bonds. Bonds
Bond is a type of long-term debt instrument, or long-term liabilities, or “publicly traded IOUs”.
It is also called “fixed income securities”, because the interest payments are fixed amounts.
For purchasing bonds, investors will receive
two types of income from the borrower or the issuing firm.
First, principal repayment. Borrower agrees to
repay a fixed amount of principal at a predetermined maturity date.
Second, fixed interest payment. Borrower agrees to pay a fixed amount of interest over a specified period of time.
For most cases, bonds are issued by private entities, corporations, or government.
Why Invest in Bonds? Why invest in bonds? First, they can provide current income for conservative investors. Because bonds pay regular interest payments to the bondholders,
so it is suitable for those conservative investors who prefer receiving stable return.
At times, they can provide capital gains for more aggressive investors. For example, if interest rates decline, the market value of existing bonds may rise,
allowing investors to sell their bonds for a profit.
Some types of bonds can provide tax-free income, such as municipal bonds. Tax-free bonds are attractive to those investors who are in higher tax brackets.
Generally, bonds can be used for capital preservation, and long-term capital accumulation. Bond Sample
This picture is a sample certificate of a bond.
The Dow Chemical Company, this is the name of the issuing firm.
$1,000, this is the principal value of the bond. It’s usually called par value or face value, to be paid to the bondholders at the maturity date.
7.625%, this is the coupon interest rate. Taking 7.625% times $1,000, the par value,
it means the bondholders will receive coupon interest payment of $76.25 every year.
July 1, 2003, this is the maturity date or due date of this piece of bond.
Corporate Bonds
Corporate bond is one of the most common types of bond.
When you buy bonds, you are basically lending money to the company. In other words, the issuing firm borrows money from you by selling bonds. So, bondholder is the lender, issuing firm is the borrower.
Bondholders invest in the bond issued by issuing firm by lending money. So, bondholders may expect to receive interest periodically, which is commonly
semiannual or annual payment, and receive principal at the end of maturity period.
For the issuing firm that borrows money from the bondholders, it promises to repay interest
and principal under clearly defined terms, such as when to pay and how much to pay.
Key Features of a Bond
The following are some key features of a bond.
Coupon, this is the amount of annual interest income. Just multiply the coupon rate by par value to get the coupon payment.
Par value, the amount of capital that must be repaid at maturity,
also known as face value or principal.
Maturity date, the date when a bond matures and the principal must be repaid.
Current yield, a measure of the annual interest income a bond provides,
relative to its current market price.
Yield to maturity, the yield or return earned on a bond from the time it is purchased until
the maturity date of the bond. It is also the discount rate used to value a bond.
Call feature, it allows the issuer to repurchase the bonds before the maturity date.
It can be freely callable, means anytime the company can buy back the bond. Noncallable, means the company cannot retire the bond until maturity date. Or deferred call,
which is a provision that prohibits the company from calling the bond before a certain date. During this period, the bond is said to be call protected.
Issuers will exercise the call feature when interest rates fall. So, the issuer can refund the issue at a lower cost, and issue new bonds at a lower rate. Call premium, this is the amount added to the bond’s par value,
and paid upon call to compensate bondholders.
Call price, the bond’s par value plus call premium.
Certain bonds also come with conversion feature, in which the convertible bonds
allows bondholders to exchange their bonds for a specified number of shares of common stock.
Bondholders will exercise this option, only when the market price of the stock
is greater than the conversion price, which will provide a profit to bondholder.
Interest Rate and Bond Price
Next, let’s talk about the relationship between interest rate and bond price.
The behavior of interest rates is the single most important force in the bond market. In other words, bond market is mainly affected by the interest rates.
Interest rates and bond prices move in opposite directions, which is a negative relationship. When interest rates rise, bond prices fall. When interest rates drop, bond prices move up.
That’s why, bond markets are bullish, when interest rates are falling or low. Bull
