Bonds

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Bonds are debt financial instruments which are issued to raise capital. In other words they are a loan made by investors to corporations, local or state governments. As mentioned, the two parties are involved: issuer, who is the borrower and holder, who is the lender. Issuer agrees to pay back the amount borrowed on maturity date (date the bond is retired) and sometimes, additionally agrees to pay interest rates during the term of the bond.

Terminology

Par Value * nominal, face value. Amount to be paid back at maturity.

Principal * represent initial cost of the investment, less any interests. It is calculated multiplying Par Value and Price ( represented as percentage)

Par Value: 100,000

Price: 97 (=97%)

Principal Cost = 100,000*0,97=97,000

Coupons * interest payments associated with the bond. They are periodically payments (monthly, quarterly, annually etc.) made by issuer to holder on payables dates. Interest rates can be both fixed or variable (usually depending on index etc.)

Trading

Bond can be issued for less than its par (face) value (Price of bond <100). It usually takes place when bond's interest rate is below current market yield. At maturity investor will receive par amount plus scheduled interest payments during the term of the bond.

In opposite, bonds can be issued above their par value (Price of bond>100) and this usually happening when the market yield is less than the bond's market value. At the maturity lender receive par value (which is less than was paid for bond) plus coupons associated.


Types

There is a large variety of bonds, the most common one are:

Zero coupon bonds * sold at large discount from face value. However, the holder does not get any periodical payments * coupons.

Junk bonds - bonds with very low ratings and high default risk. Issued usually by corporations struggling with financial problems or in bankruptcy. They may attract investors due to their very high interest rates.

Eurobond - issued and traded offshore, denominated in currency other than issuer's country. Usually a bond issued by a non-European company for sale in Europe. They are named after the currency they are denominated in. For example, Euroyen bonds are denominated in Japanese yen.

Often bonds are offered on auctions to get the highest possible price.


References

  • All about bonds and bond mutual funds: the easy way to get started, Esmi Faerber, McGraw-Hill 1999, p.21
  • Financial risk manager handbook Philippe Jorion ; GARP. Hoboken : John Wiley & Sons, 2005, p.3


Author: Katarzyna Wierzbinska