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Bond (financial)
From Citizendium, the Citizens' Compendium
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A bond is a form of debt that occurs when an investor loans money to the government, a corporation, or an institution.
A bond is an interest only loan. Bond’s sell at face or par value, that is generally in multiples of thousands. The face or par value is the principal amount of the bond that will be paid at the end of the loan. The bondholder will collect the coupon payment or stated interest payment on the bond but will not receive the principal until the bond reaches maturity. Maturity is the number of years a bond takes to pay off its principal amount.
There are several types of bonds such as government bonds, zero coupon bonds, floating rate bonds, and convertible bonds. When the government wishes to borrow money it sells government or treasury bonds. U.S. treasury bonds have no default risk because the treasury always has money. Treasury bonds are also exempt from state income taxes. Zero Coupon bonds pay no coupons. Since no coupons are paid, these bonds are sold at a high discount. With zero coupon bonds the future dollar value is usually known. Floating rate bonds have varying coupon payments as a result of interest rates. The value of a floating rate bond depends on the effects interest rates have on the bonds coupon. Floating rate bonds have the following features. They have a put provision which entitles the bond holder to redeem the bond at par value on the coupon date at a specified time. Floating rate bonds also have a minimum and maximum coupon at which the bond is capped. One type of floating rate bond is inflation linked. An inflation linked bond is subject to coupon adjustments due to inflation. A convertible bond gives the bondholder the right to convert the par amount of the bond for common shares of stock at a specified price
To earn a higher return on a bond one must take greater risks. One may also purchase a bond that has little risk but will receive a low return on their investment. Higher risk bonds have higher yields in order to compensate the investor. When the yield on a bond is too low, its price will fall due to market expectations. Bonds are subject to several kinds of risk such as interest rate risk, inflation risk, and credit or default risk. Interest rate risk is when rates increase bond prices fall and as rates decrease a bonds price raises. The longer a bond has until maturity, makes the bond more sensitive to interest rate risks. There is also the risk of inflation. Inflation has a direct correlation with purchasing power. What money is currently valued at may have less value in the future. Inflation would cause a decrease in cash flows and would lead to higher interest rates, causing a bonds price to fall. Credit or default risk is the possibility that the issuer of the bond will fail to make payments when they are due. Corporations pay to have their bonds rated. Bonds are rated based on the credit worthiness or how likely a corporation is to default. Bond rating companies such as Standard and Poor’s and Moody’s rate bonds, but their rating system is different in terms of letters and numbers used. Treasury bonds are rated the highest and junk bonds are rated lowest.
Bond Rating Grades Credit Risk Moody's Standard and Poor's Investment Grade Highest Quality Aaa AAA High Quality Aa AA Upper Medium A A Medium Baa BBB Not Investment Grade Lower Medium Ba BB Lower Grade B B Poor Grade Caa CCC Speculative Ca CC NoPayments/Bankruptcy C D In Default C D
Bonds are bought and sold through bond dealers. Bond dealers have traders who work for them who know the bond market and are extremely knowledgeable of bond prices due to the fact they are constantly buying and selling them. Dealers provide liquidity for bond investors, allowing them to buy and sell bonds with limited concession on price. Dealers also buy bonds amongst themselves. Dealers make money on the spread the bonds are bought and sold at. The spread is the difference between what they sell them for and what they own them for, otherwise known as profit.
The indenture is the written agreement between the borrower and lender which details the terms of the agreement. This is sometimes referred to as the “deed of trust.” A bank is usually appointed by the corporation to represent the bondholders. The bank must make sure the terms of the indenture are obeyed, manage the sinking fund, and represent the corporation in default, or failure to pay. The bond indenture is a legal document and generally includes the following provisions such as terms of the bond, total amount of bonds issued, description of collateral, repayment arrangements, call provisions, and details of protective covenants.
To determine the value of a bond, one needs to know the number of periods until the bond reaches maturity, the face value, the coupon payment, and the market interest rate. The interest rate required in the market on a bond is also known as the yield to maturity. Bonds are affected by interest rates. This is known as the interest rate risk. A bonds interest rate risk depends on its time to maturity and its coupon. The longer the time a bond has to reach maturity, the more sensitive it is to interest rate risk. A bond with a lower coupon rate also has a greater interest rate risk.
How to value a bond … Suppose Mike and Pat both have 8% coupons bonds that make semi-annual payments and are priced at par value. Mike’s bond has 3 years to maturity and Pats has 20 years to maturity. Here is the formula you would use to value their bonds. Coupon [1-1/(1+ rate ^ YTM) / Rate) + Face Value/(1+ rate^YTM) Notice this bond is sold at par, making the face value= $1,000. The bond also makes semi-annual payments, so the YTM will be multiplied by 2 and the rate as well as the coupon will be divided by 2. Mike’s Bond: 40[1-1/(1.05 ^ 6) / .05)] + 1000/(1.05^6) = $949.24 Pat’s Bond: 40[1-1/(1.05 ^ 40) / .05)] + 1000/(1.05^40) = $828.41
To get more information retaining to bonds you can go to “Treasury Direct” or “CNN Money” at the following web addresses. http://www.savingsbonds.gov http://money.cnn.com/markets/bondcenter
Works Cited
"Bond Ratings." Money-Zine. 29 Apr. 2008 <http://www.money-zine.com/Investing/Investing/Bond-Ratings/>.
"Moodys Investors Service." Moodys. 28 Apr. 2008 <http://www.moodys.com/cust/default.asp>.
Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordan. Essentials of Corporate Finance. New York: McGraw HIll, 2008.
"Standard & Poors: United States." Standard & Poors. 28 Apr. 2008 http://www2.standardandpoors.com/portal/site/sp/en/us/page.home/.
