Additional Resources

  1. Common Risk Factors In The Returns On Stocks And Bonds* [rady.ucsd.edu]
  2. Principles Of Macroeconomics [colorado.edu]
  3. Business Conditions And Expected Returns On Stocks And [www-bcf.usc.edu]
  4. Green Bonds: Green Grow The Markets, O [webfeeds.brookings.edu]
  5. Economics 001 Principles Of Microeconomics [faculty.georgetown.edu]
  6. The Market For Borrowing Corporate Bonds [economics.mit.edu]

Bonds

Bonds are debt securities/instruments that certify a contract between two parties, the bond issuer (borrower) and the bondholder (lender/investor). The investor lends the money to the borrower by purchasing a bond. The bond legally binds the lender into a contract where the lender must pay a certain amount of money to the bondholder at a specified/predetermined interest rate also known as the coupon rate and at pre-decided times (the coupon dates).

The lender/bond issuer must repay the principal (bonds' face value) once it matures. In other words, the issuer must return the bond's stated par value at the maturity date or the date of expiration. Bonds are mostly issued by entities like the government, corporations, municipalities and federal agencies. These are mostly issued to raise money for new projects and refinance existing debts. The interest rate on bonds can be both fixed and variable. However, they are mostly offered at fixed rates.

Some government and corporate bonds are traded publicly on exchanges while some are traded over the counter.

Understanding the Mechanics - How Bonds Actually Work?

Instead of applying for loans from banks, corporations and other business entities often opt for bond issuance. These bonds are issued directly to lenders. The bond, when issued, states the interest rate and maturity date.

Generally, the price of bond issuance is set-at-par. This is either 100 US dollars or 1000 US dollars face value/individual bond. Here, it is important to understand that the real market price of the bond largely depends on the following factors:

  • The bond issuer's credit quality
  • Time length until expiry
  • Coupon rate in comparison to the interest rate generally prevailing at that time

Let's take a look at some examples of how bonds with fixed interest rates work:

If the borrower issues a bond when the prevailing interest rate is 5 percent at 1000 US dollars par value and the annual coupon rate is 5 percent, then the bondholder will receive cash flows of $50 annually. In case the interest rate drops to four percent, the bondholder will continue to receive payments at 5 percent. This will make investing in bonds more attractive.

On the other hand, if the interest rate rises to 6 percent, the 5 percent coupon will no longer remain attractive.

Basic Characteristics of a Bond

  • Face Value The worth of the bond at the time of maturity
  • Coupon Rate The interest rate at which the issuer of the bond will pay to the investor
  • Coupon Dates These are the interest payment dates (semiannual or annual)
  • Maturity Date The date when the bond will expire
  • Types of Bonds

    • Sovereign Government Bond These are issued by the sovereign government and include Treasury bills as well as agency bonds.
    • Municipal Bond Municipal bonds are issued by the local and state governments. They are often tax free.
    • Corporate Bond As the name suggests, these bonds are issued by partnerships, corporations, commercial enterprises and LLC (limited liability companies). These bonds offer higher yields as compared to other bonds.
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