BONDS
Investing in a bond is a safer and less risky alternative to other investments such as stocks or real estate. Generally bonds are issues by both companies and governments.
So in other words we can say, that bond is a kind of loan, where the issuers the one who borrows and the holder is the one who lends, and the interest added is the coupon. Bonds can prove to be a good source to provide the borrower with funds to finance the long term investments. Also they may be of help in financing the current expenditure.
Why issue bonds?
Companies and governments both issue bonds for the same reason, as a way to raise capital. Companies can use bond issuance instead of stock issuance to raise capital while governments cannot issue stock as they have no equity to distribute. Bonds can potentially bring in more capital than a bank loan could and can be cheaper for the company than stocks.
How Bonds Work
Bonds have a variety of features that help determine their value to the investor.
- Face Value – this can also be called the nominal amount, face amount or principal value. This is the amount that the bond issuer has to pay at the end of the bonds life.
- Maturity – this marks the end of the bonds life and is the point at which the issue must repay the face value to the borrower. Companies can issue a wide variety of maturity’s on their bonds but U.S. government sticks to a tiered system. Treasury bill mature in up to one year, Treasury notes mature between one to ten years, and Treasury bonds mature in ten years or more.
- Coupon – this is another name for the interest rate. The issuer of the bond agrees to pay the fixed interest rate on the bond every year until maturity. The coupon rate is fixed throughout the life of the bond and, along with the face value, is how investors value the bond after it has been issued.
- Issue Price – This is the price of the bond when a company or government issues the bond. This value is given by an equation calculating the present value of both the maturity and coupon rate.
Calculating Bond Value
Bonds are fairly simple instruments to calculate when they are issued. Let’s assume that a 20 year bond is being issued by a company with a face value of $1000. The company agrees to pay a $30 a year coupon on the bond until maturity. This gives an interest rate of 3% (30/1000). Let’s also assume that the market interest rate on similarly risky investments is 3%, the same value as the bonds coupon rate. The numbers are then applied to a formula generally using a financial calculator and the resulting Issuance price is $1000. In this case the issue price is the same as the face value and the bond issuer is paying the borrower for the time value of that money.
Bonds can be freely traded on the market at any point in their lifespan. This requires investors to know how to calculate a bond’s value at the time of purchase. There are three different categories a bond can fit into when it’s being sold after its issuance.
- Par Value – The primary indicator of a bond’s value is the coupon rate it pays out to the holder. This coupon rate is compared by investors to the market interest rate. In a situation where a bond is at par value, the market interest rate and the bond’s coupon rate are the same. In our earlier example this would mean that the coupon rate is 3% and a few years down the line, the market interest rate is also 3%.
- Premium – A bond is considered to be a premium bond when the interest rate on the bond is higher than the interest rate in a market, this generally occurs during a recessionary period. An example of this would be that 5 years after issues, our 20 year bond is still paying out 3% or $30 on its $1000 face value as the coupon rate does not change throughout the life of the bond. But the market interest rate happens to be only 2%. After entering this into a financial calculator, the bond is valued at $1128.49. This price is increased because a bond which is at a premium value is yielding more interest than an investor can normally get from the market, therefore it is worth more.
- Discount – A bond at a discount rate is the exact opposite of a bond at a premium rate. In this example let’s assume that 5 years down the road, the market interest rate is 4% due to good financial times and an upturn in the economy. The bond features are all the same at a coupon rate of 3% and a face value of $1000. Calculating the price of the bond now gives a value of $888.82. This price is now lower because the bond is yielding less than an investor can get on the market therefore would not be willing to pay the full face value for a worse investment.