Explain Bonds
A bond is a security representing a loan. It is a liability for the issuer (usually a government or company), and an asset for the bondholder (usually an entity or individual investor). A bondholder is an individual or entity that has loaned money to the bond issuer.
Bond Terms
Par Value – Par value is the amount of money (usually $1000 per bond) that will be returned to the bondholder at the maturity date.
Coupon – The interest the bond pays annually.
Coupon Rate – This is the interest rate of the bond which is the coupon divided by par value.
Maturity – The length of time before the bond issuer pays the par value to the bond holder.
Bonds Price and Yield
If the bondholder purchased a bond at par when issued, the price would be $1,000 and the yield would be the coupon rate. But most investors purchase bonds at a price over or below par value. Many of these purchases are made on the secondary market where bonds are traded regularly (i.e. similar to a stock exchange), making buying and selling bonds easy.
The market price of the bond will most likely be more or less than the par value (the amount paid the bondholder at maturity). The bondholder will still receive the coupon or interest (usually semi-annually) and the par value at maturity.
Current Yield – is the coupon (interest) divided by the current market price of the bond, which may be more or less than the par value.
Yield to Maturity – is the amount of return a bondholder would make on the bond if bought at market value and held to maturity. This is a complicated calculation usually supplied by the bond broker or exchange. The yield to maturity takes into account the coupon paid until maturity and the difference between the market price of the bond and par value. If the market price is lower than par value, the yield to maturity will be higher than the coupon rate because the bondholder will receive more money (par value) at maturity than the price paid for the bond. If the market price is higher than par value, the yield to maturity will be lower than the coupon rate because the bondholder will receive less money (par value) than the price paid for the bond.
Bond Risks
Bonds have two main types of risks that every investor should understand before purchasing a bond (making a loan).
Credit Risk – This is the risk that the issuer will be unable to pay the coupon (interest) and/or par value at maturity. The financial position of an issuing entity can change over time affecting the price of the bond before maturity.
Interest Rate Risk – The price of a bond moves in the opposite direction of bond yields. Since the coupon (interest) on the bond is fixed, the price of the bond will rise or fall to provide a yield to maturity on the bond equal to the current market rate. Therefore, when interest rates change, the change in price of the bond is greater for a bond with a long maturity than a bond with a short maturity. When interest rates change, the price of a bond will rise or decline to provide the current market yield to maturity over the remaining life of the bond.
Bond ownership is one of the foundations of capitalism and a free enterprise system. The risks of owning bonds can be partially mitigated through a risk management plan that includes a tactical asset allocation strategy.
Related Reading: Should You Buy Government Savings I-Bonds?
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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