A bond is a debt security or an official kind of IOU.
They are used to raise money for a government,
municipality, or corporation. This kind of contract
sets up the:
1.Maturity date and length of time to borrow the
money, such as 1 year, 10 years, 30 years
2.Interest rate
3.Interest payment dates; usually semi-annually or
annually, but sometimes monthly
4.Face value of the bond or the amount paid out
at maturity
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Knowing the different categories of bonds and
their strengths and weaknesses helps you diversify
more accurately. Each type responds to a different
market cycle. Bonds are categorised by issuers,
payment, and even location or currency. The first
three kinds of bonds are the most common ones.
Treasury Bonds are a loan to the issuing
government or government body. These are often
called government bonds. There strength is based
on the faith one has in the government. Thus US
bonds would be considered safer than bonds
issued by Zimbabwe.
Municipal Bonds are a debt to cities, states, or
other public entities. Often these are issued to
create funds to build roads, schools, hospitals,
and other public projects. Some municipal bonds
have tax advantages. Some of these bonds may
be revenue bonds. The interest and principal on
these bonds are paid by the collection of tolls or
fees from a specific project.
Corporate Bonds are a debt to corporations
issued to raise money for capital improvements,
acquisitions, or refinancing old debt. Independent
companies rate bonds with ratings such as AAA+ to
DDD-. Bonds can also be secured or guaranteed.
• Secured. Secured bonds are backed by assets
from the company.
• Guaranteed bonds have a second party such as
an insurance company guarantee the bond will
be paid.
• Investment grade bonds are from companies
with a rating of BBB- or better.
• High yield bonds or junk bonds come from
companies with ratings below BBB- or businesses
that are considered less stable. The yield on
these bonds are usually higher than other bonds
to compensate for the increased risk of default
Interesting to note: bondholders get paid before
shareholders. So junk bonds may be more secure,
9.1 Kinds of Bonds
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but perhaps less liquid, than stock in the same
company.
Foreign Currency Bonds are issued in a currency
different from the originating country. The issued
currency might be more stable than the issuing
country’s currency. It can be used to help a
company break into foreign markets or be a hedge
against foreign exchange risks.
Perpetual Bonds have no redemption date. They
have little principal value as their only real value
comes from interest payments.
Zero Coupon Bonds or discount bonds pay no
regular interest over the bond period. Instead, you
pay much less for them than the face value. As you
hold them, the interest accrues and you are paid
the full face value at maturity.
Sometimes the interest paid on bonds is called a
‘coupon’. This is because paper bonds of the past
had coupons attached to the bond. When the
bondholder was due interest, he’d take the coupon
to the bank to redeem it for the interest.
Zero coupon bonds have no ‘coupons’. That is,
they pay no interest for the duration of the bond.
Instead, the price of the bond is based on the face
value and accrued interest. The closer to maturity,
the more value the bond has.
Bond Math
Finding the Yield Rate
Annual Interest Payment - yield rate
Current Price
Finding the Sale Price:
9.2 Earning Money with Bonds
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Factors:
• All interest earned to maturity
• Remaining life of bond
• Face value
• Current market value
Market price is a percentage of the face value
If you choose to hold a bond to maturity, the price
and value are simple. You buy a bond. You receive
interest, and at maturity, you get your money back
(as long as the bondholder does not default.) If
you consider buying or selling your bond before
maturity, figuring out the market value of a bond
is trickier.
To calculate the market value of a bond before
maturity, you must first find the yield rate. This
comes from dividing the annual interest payment
by the current price. Remember, the current price
of the bond uctuates based on:
• Interest rates
• Risks of the issuer
• Demand
• Other factors
For example, if interest rates rise, bond prices will
fall. This is an inverse relationship. If a company
receives a downgraded rating, its bond prices will
fall. Any fear of default reduces the bond price. If
interest rates drop, bond prices may rise - even
going higher than their face value. The market price
is listed as a percentage of the assigned value.
The sale or exchange value of a bond takes into
consideration all the above factors. The yield to
maturity, or redemption yield, also considers the
remaining life of the bond, the bond face value,
and the market value of the bond. The U.S. market
typically quotes a at or ‘clean price’ which is the
face value price only. Other countries may quote a
full or ‘dirty price’ which includes the face amount
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may quote a full or ‘dirty price’ which includes the
face amount plus interest accrued to the maturity
date.
Buying and Selling: Most bonds are initially
bought from the issuer in lots by banks, central
banks, hedge funds, or insurance companies.They
may then be sold to the general public. Banks may
charge a commission on the sale or they may make
their profit on the buy/sell spread.
You can buy new bonds or buy them on the
secondary market. There is not a bond market in
the same way there is a stock exchange. The bond
market is decentralised and dealer based. Usually
a bank or securities firm buys the bond and either
keeps it or resells it. It may be easier for investors
to buy a bond fund. This fund holds the bonds, but
now you can buy and sell just like a stock.
Rewards and Risks: Investors choose bonds for the
steady income they offer. When purchased from a
highly rated entity and held to maturity, investors
can determine exactly how much they might
expect in returns. As a debt holder, bondholders
have an advantage over equity or shareholders.
If a corporation or business goes bankrupt,
bondholders get paid first.
But all investments carry risk and bonds are no
different. Here are some of the possible risks.
• Credit Risk: If the issuing entity defaults or goes
bankrupt, bondholders may lose their principle
If the company is downgraded, bond price will
fall resulting in lower resale price. Price uctuation
does not affect the bondholder if you intend to
hold the bond to maturity.
• Revenue Municipal Bonds: Revenue bonds
come from things like toll roads, landfills, or other
municipal projects that produce income. If the
revenue source dries up, the municipality may
not be obligated to pay off the bond. You could
lose the principal you invested.
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• Callable: Corporations or cities may call the
bonds or pay them off early. They will pay face
value, but you lose the income ‘coupon’. Usually
this happens when interest rates are falling, so
you may not find as favourable a rate when you
reinvest your money.
• Interest Rate Risk: If you sell before maturity,
you are subject to market value. Rising interest
rates may price your bonds below the face value
and you lose part of your original investment.
• Liquidity Risk: Since bonds do not sell on an
official market you may not be able to sell your
bonds as quickly as you want or exactly when you
want to. The resale market for buying and selling
bonds is much smaller than new purchases. While
there are over two million bonds in existence,
only a small percentage - perhaps tens of
thousands - change hands on any one day.
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Bonds have traditionally been considered one
of the safest investments. The returns are fairly
predictable and the volatility is lower than most
any other investment vehicle. Some investors are
happy to get lower returns along with lower risks.
Advisors often recommend bonds for retirees and
other people on fixed incomes. These people may
not be able to afford the risk of higher volatility
found in other investments.
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Your capital is at risk. Past performance does not guarantee future results. This information is for educational purposes and not investment advice.
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