Wednesday, January 28, 2009

What is a bond?

A bond is a an investment instrument that is simply a debt. There is someone who has the money and that is you, and an entity that needs the money. This entity will borrow the money from you and in return you will obtain interest.

Companies and governments needs money for a variety of purposes and one of the way they can get the money is to issue bonds. As a result when an entity issues bonds, investors like you will buy these bonds and the company will get the money. Hence a bond is simply an IOU that the entity will give to you so that later on you will get your money back.

Before buying the bonds, we need to know about some characteristics of bonds.

Face Value OR Par Value OR Principal

This is the amount that you will get when you present your bond when it matures. The result it is called the face value is because this value will be written on the bond certificate. So if you have a bond that matures in ten years and that its par value is $ 1000, it means that you will get $1000 when it matures.

However bonds are not sold at par value. It can be sold at a discount, at par or at a premium.

1. At a discount. These bonds will be issued at a price lower than the par value.

Bonds are usually discounted at a percentage called the discount rate. Now suppose that a bond of par value $1000 is issued at a discount rate of 5%. At what price would you buy it?

Buying price = (100 - Discount rate)/100 * Par value
= (100 - 5) /100* 1000
=$ 950

So this bond will be sold at $950.

2. At par. These bonds will be issued at a price that is the same as the par value that is $ 1000.

3. At a premium. Some bonds that are in great demand will be sold higher than the par value. Now suppose that a bond of par value of $1000 is issued at a premium rate of 10%.
At what price would you buy it?

Buying price = (100 + premium)/100 * Par value
= (100 + 10) /100* 1000
=$ 1100

So this bond will be sold at $1100.

Coupon Rate or The Interest Rate

The coupon is the amount that you would receive year until the maturity date. The bond will then have a coupon rate that may or may not be the same as the discount rate. However most bond pay twice a year and as a result the bondholder will receive a payment twice a year.

Let say that you have a bond of par value $1ooo with coupon rate 6%.

Coupon or interest received = interest rate/100* par value
= 6/100*1000

Hence the coupon payment is $60. If the payment is done twice a year then you would receive $30 every six months.

Maturity Date

The maturity date is the date when the issuer will repay you your money. As mentioned above you will get an amount equal to the par value.This will range from a few months to 30 years.

Note that for government bonds special names are used depending on the time to maturity.

Treasury bills - maturing in less that one year
Treasury notes -maturing from 1 year to 10 years
Treasury bonds -Maturing in more than 10 years

Why invest in bonds?

1. Bonds are less risky than other instruments. Read this post on risk to understand why. However keep in mind that bonds have lower return and that some bonds may be riskier depending on the issuer.

2. Some people need a regular source of income. Because some stocks may not pay dividends on a regular basis then bond coupon payment will offer a regular income.

3. Because bonds are safe investments, you may invest your money in them if you do not want to lose your money. Especially if you need it in the near future.

4. Bonds are also a major part of the investment portfolio of people that have a low risk tolerance.

What is a bond?
Stocks have higher return than bonds
Introduction to diversification
What is a bond ladder?

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