What are bonds


Everybody is talking about Bonds, but do you really know what Bonds are and how they work?

What are bonds?

  • Bonds are units of debt, which are issued by the government or a company when they want to raise money, which an investor can buy to be paid interest over a defined time period.
  • The investor gets paid an agreed amount of interest for the time, he lends the money to the borrower.
  • The borrower can use the money for his investments over the agreed time period.
  • The borrower is bound by contract to repay the loan with added interest to the investor.

Want to learn more about bonds? Read on.


What are Bonds in detail?

In general, you can look at bonds as a simple loan. By purchasing a bond, you lend the government or company money for a fixed duration. During this duration, you will receive interest payments, which are either paid during the term, for example on an annual basis, or at the end of the term, when the government or company will also return the lent sum back to you.

The interest rate you get can be fixed or variable. It is for example possible, to peg the interest rate to inflation, which will make it easier for the investor to know what he gets in terms of value over time.

Bonds don’t have to be held until the end of their term. Bonds can be usually bought and sold through the “secondary market” after they have been issued. Bonds are either traded through public exchanges or over-the-counter between large broker-dealers which act on their client’s behalf.

The price yield of the bond is determined on the secondary market.

Bonds are considered a safer form of investment than stocks because their prices are less volatile. But there are several factors that play into a bond’s value, that have to be understood, such as credit rating, maturity, nominal value, the value on the secondary market, and coupon.

What is a Bond Credit Rating?

If you lend money to the government, the risk of losing your investment is very small. Governments usually don’t default and have always the option to print new money. Therefore lending to the government is considered very safe, but the interest rates will therefore also be lower. If you lend money to a company the chance that the company defaults is higher. Because the risk to lend money to a company is higher, the interest rates will also be higher. Some companies offer guarantees, that in case they default, they can still meet their obligation and pay the money back, by selling some of their assets. Other companies are unable to do that, so if they default, then it means you might not get your money back.

In order to determine the risk of a bond, there are rating agencies, which will rate the creditworthiness. The most known US rating agencies are Standard & Poor’s, Moody’s, and Fitch. They rate the bonds based on the risks between AAA (which is best) and C or D (which is worst). In theory the higher the risk to lend a company money, the higher the interest rate payment is expected. The rating agencies are not always right, therefore it is important, that you do your own research to determine how stable the company is, and if it offers a guarantee to investors, that it can fulfill its obligations, even if it defaults or not.

  • Standard & Poor’s (AAA to D)
  • Moody’s (AAA to C)
  • Fitch (AAA to D)

Bonds that are above Standard & Poor’s, or Fitch’s BBB, or Moody’s Baa, are considered investment-grade bonds. Everything below these ratings is sometimes referred to as junk bonds, as these companies are more likely to default.

If you are looking for details on the rating scales, you can refer to following sites: Standard & Poor’s, Moody’s (PDF), Fitch.

What is a Bond Maturity?

Maturity is the term length, of a Bond. This can be short term, mid term or long term.

  • Short Term Bonds (1-3 years)
  • Mid Term Bonds (up to 10 years)
  • Long Term Bonds (over 10 years)

What is a Coupon in relation to a Bond?

A coupon is the interest rate that you get paid for lending out your money.

What is the nominal value of a Bond?

The nominal value of a bond is the initial price, that the government or a company has set, to issue the a bond.


What is the difference between a Bond and a Stock?

When you buy bonds, you lend money to the government or a company over a fixed term length, and will be paid interest for the time you borrow them your money. 

When you buy shares you become co-owner of the company and participate in its profits and losses. If the company does well you will be usually paid dividends and the stock price increases. If a company does not so well, the stock price falls and the company might decide to no longer pay dividends.


What are the costs of Bonds?

If you want to invest in bonds, you should look carefully at the costs in advance. In some cases, the fees can significantly reduce your return.

Bonds usually come in a minimum denomination, to which it was issued. A company for example can issue bonds to the value of $1000 per bond, which means, that the smallest bond you can purchase will be a $1000 bond.

In addition to the usual taxes on interest income (some government bonds might be exempted from taxes), you have to pay custody costs for managing your securities account, and if you want to buy or sell bonds, you might have to pay a fee too.

If you invest with a bank, they usually expect you to purchase bonds to at least a few 10’000 dollars, as it otherwise is not lucrative for them. But there are also Bond ETFs out there, which can be bought through online brokers and can be bought individually.

When investing in bonds in foreign currencies, exchange rate costs must also be paid.


What are the risks of Bonds?

The risks depend on the companies ability to repay their obligations, in case they default. You need to know, if a bond is secured, or unsecured, and what it’s rating is. If you purchased a secured bond, and the company defaults, then the company will be able to partially or fully repay by selling the assets, to which the bond was backed. If you purchased an unsecured loan and the company defaults, then after the company has sold all its assets, debt will have to be paid off first, which means that the money of remaining sold assets will be paid out to lenders first, before shareholders (that purchased stocks) get anything.


How do I calculate the simple interest rate of a bond?

Let’s assume that the government wants to invest in a new fire department. They decide to issue bonds. Each bond is initiated to a value of $1000 per Bond (also called Face Value). The term (also called Maturity) of the bond is 10 years. Each bond will pay an annual interest rate (also called Coupon Rate or Coupon Yield) of 5%.

Let’s assume you decide to buy 1 Bond as face value (initial value). By doing this you give $1000 to the government. The government then pays you 5% of $1000 ($50) every year. So over 10 years you will receive a total of $500 (10 years * $50) in interest payments.

At the end of the 10 years (Maturity of the Bond), you will now also receive back the $1000 you have invested. So in total after 10 years, you will have received back $1500.

YearsPayments / IncomeDescription
Year 0-$1000You purchase the bond.
Year 1+$50You receive the annual interest payment.
Year 2+$50You receive the annual interest payment.
Year 3+$50You receive the annual interest payment.
Year 4+$50You receive the annual interest payment.
Year 5+$50You receive the annual interest payment.
Year 6+$50You receive the annual interest payment.
Year 7+$50You receive the annual interest payment.
Year 8+$50You receive the annual interest payment.
Year 9+$50You receive the annual interest payment.
Year 10+$1050You receive the annual interest payment & the initial investment sum of $1000.
Bond Maturity reached+$1500

How do I calculate the interest rate of a bond that is already on the market?

As previously mentioned bonds can in most of times be bought and sold through the secondary market.

Interest rates rise

If the monetary authority decides to raise interest rates, it means that new bonds will be issued with a higher interest rate, which is more attractive for investors. If this happens, then the demand to buy an existing bond with a lower interest rate will decrease, while the demand for new bonds will increase. Therefore the price of the existing bond will fall, because many investors will want to purchase the new bonds with the higher interest rate. Let’s say, the price of the bond which was $1000 initially, is now at $800. How much yield would you get from it annually now?

  • Coupon Yield: 5%
  • Coupon: $50
  • Par Value: $1000
  • Price: $800

Coupon / Price * 100 = Current Yield

$50 / $800 * 100 = 6.25%

or (((5% * $1000) / $800) * 100)

Interest rates fall

  • Coupon Yield: 5%
  • Coupon: $50
  • Par Value: $1000
  • Price: $1200

The same formula can be used if the interest rates go down, and existing bonds have a higher yield, then new bonds. Let’s say the price of the bond is now at $1200, due to higher demand.

Coupon / Price * 100 = Current Yield

$50 / $1200 * 100 = 4.17%

or (((5% * $1000) / $1200) * 100)

Bond Yield to Maturity

Yield to maturity (YTM) is the total return that is anticipated, if the bond is held until it matures. Here it gets a little abstract and goes into more complex math.

Let’s take our first example from above. Our Coupons are already paid annually. That’s why the Coupon Frequency is 1. If we would be paid half yearly, then the coupon frequency would be 2.

  • Face Value (Initial Value): $1000
  • Current Price: $800
  • Years to Maturity: 5
  • Annual Coupon Rate: 5%
  • Coupon Frequency: 1
  • Annual Interest Payment: ?

Let’s calculate the Annual Interest Payment first:

(Face Value * Annual Coupon Rate) * Coupon Frequency = Annual Interest Payment

($1000 * 5%) * 1 = $50

or ((1000 * 0.05) * 1)

So now we have the following parameters including the Annual Interest Payment:

  • Face Value (Initial Value): $1000
  • Current Price: $800
  • Years to Maturity: 5
  • Annual Coupon Rate: 5%
  • Coupon Frequency: 1
  • Annual Interest Payment: $50

Based on this we can now do the hard math:

((Annual Interest Payment + ((Face Value – Current Price) / Years to Maturity)) / ((Face Value + Current Price) / 2 * 100)

((50 + ((1000800) / 5)) / ((1000 + 800) / 2)) * 100 = 10

You can copy and paste the numbers into the Google search field, and you should see a calculator with the result, to check or amend the formula to your numbers.

You can also use DQYDJ, if you want a calculator to calculate the value, or if you want to learn more details about the formula.


More Info

Below a Youtube Video from Ameritrade, that explains Bonds in a very easy way.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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