Bonds are the time capsules of money, used by the companies, municipalities, sovereign governments and states to finance new operations and projects. The owners of the bonds are debtholders or the creditors. Bonds are commonly referred to as fixed income securities and are one of the asset classes individual investors along with the cash and stocks equivalents. When companies need to raise the money to finance new projects, they may issue bonds directly to the investors. The issuer issues the bond including terms of the loan and interest payments that are to be paid back. The interest rate is a part of the return that the bondholders earn for loaning his funds to the borrower. The interest rate then determines the payment called the coupon rate.
Read about Bond Trading
The initial price of the bond is set up usually like $100 or $1000 face value per bond. The actual price of the bond depends on factors like the credit quality of the issuer, coupon rate compared to general interest rate and length of time until the expiry of the bond. The face value is to be paid back to the issuer once the bond matures. Most of the bonds are sold by the initial bondholder to other investors. Therefore, it is common for bonds to be repurchased by the borrower if the interest rate declines or if the credit of the issuer has improved. Most of the bonds share common basic characteristics including:
- The Face Value
The amount of money which is held until the bond reaches its maturity. It can also be defined as the amount of money that the bond issuer uses at the time of calculating interest payments. For instance, take an example of an investor who buys a bond at a premium of $1000 and another one buys the same bond later at a discount for $900. When bonds will get matured, both of them will get the same face value for the bond, say $1000.
- Coupon Rate
The percentage amount of money, the bond issuer will pay on the face value of the bond. For example, a 6% coupon rate means that the bondholder will receive a 6% x $2000 face value of $120 every year.
- Coupon Dates
The dates on which the bond issuer is expected to make the interest payment to the creditor in a given interval.
- Maturity Date
The date on which the bond will mature and the issuer has to pay the bondholder to face the value of the bond.
- Issue Price
The price at which the bond issuer originally sells the bonds.
Two main features of a bond are credit quality and maturity. If the issuer has a poor credit rating, then the bonds will pay off more interest. Also, bonds with a long maturity date, pay off a higher interest rate as the bondholder is more exposed to interest rate and inflation risks. The sensitivity to change in the interest rate environment is called duration. This is a confusing term for the new bond investors as it doesn’t refer to the length of time the bond has before the phase of maturity. Instead, it describes how much a bond price can rise or fall with a change in the interest rate.
Therefore a bond fluctuates throughout its life in response to a number of variables, maturity and interest rates. Keeping all these characteristics and features in the head, a trader can buy or sell bonds with ease. Always remember one golden rule of the bond market,” Once you’ve mastered some of these features, you are ready to unmask market dynamics”
Types of Bonds