Investing in Bonds
What is a Bond
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. A bond has an end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments that will be made by the borrower. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.
Owners of bonds are debtholders, or creditors, of the issuer.
Breaking Down Bond
Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
The Initial Price of most bonds is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.
Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.
Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the market price of the bond will fluctuate as that coupon becomes more or less attractive compared to the prevailing interest rates. Furthermore, whilst blue chip FTSE 100 companies can provide a strong source of dividend income, mid cap and smaller companies, such as those listed on the FTSE 250 and their global equivalents, have historically offered greater growth potential. As with investments in general, asset allocation should be thought of as a long term strategy, with adjustments to take account of market conditions being made on a more gradual basis.
Imagine A Bond that was issued with a coupon rate of 5% and a $1,000 par value. The bondholder will be paid $50 in interest income annually (most bond coupons are split in half and paid semiannually.) As long as nothing else changes in the interest rate environment, the price of the bond should remain at its par value.
However, if interest rates begin to decline and similar bonds are now issued with a 4% coupon, the original bond has become more valuable. Investors who want a higher coupon rate will have to pay extra for the bond in order to entice the original owner to sell. The increased price will bring the bond’s total yield down to 4% for new investors because they will have to pay an amount above par value to purchase the bond.
On The Other Hand, if interest rates rise and the coupon rate for bonds like this one rise to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and begin selling at a discount compared to par value until its effective return is 6%.
The bond market tends to move inversely with interest rates because bonds will trade at a discount when interest rates are rising and at a premium when interest rates are falling.
Most bonds share some common basic characteristics including:
Face Value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium$1,090 and another purchases the same bond later when it is trading at a discount for $980. When the bon matures, both investors will receive the $1,000 face value of the bond
Coupon Rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
Maturity Date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
Issue Price is the price at which the bond issuer originally sells the bonds.
Two Features of a Bond, credit quality and time to maturity – are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate because the bond holder is more ex-posed to interest rate and inflation risks.