Economic Jargon : Bond Basics
Introduction
The first thing that comes to most people's minds when they think of investing is the stock market. After all, stocks are exciting. The swings in the market are scrutinized in the newspapers and even covered by local evening newscasts. Stories of investors gaining great wealth in the stock market are common.
Bonds, on the other hand, don't have the same sex appeal. The lingo seems arcane and confusing to the average person. Plus, bonds are much more boring - especially during raging bull markets, when they seem to offer an insignificant return compared to stocks.
However, all it takes is a bear market to remind investors of the virtues of a bond's safety and stability. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds.
.
What Are Bonds?
Have you ever borrowed money? Of course you have! Whether we hit our parents up for a few bucks to buy candy as children or asked the bank for a mortgage, most of us have borrowed money at some point in our lives.
Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).
Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity.
For example, say you buy a bond with a face value of Rs.1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of Rs.80 (Rs.1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of Rs.40 a year for 10 years. When the bond matures after a decade, you'll get your Rs.1,000 back.
Debt Versus Equity
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest.
To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.
Why Bother With Bonds?
It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true:
1) Retirement - The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
2) Shorter time horizons - Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.
These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of fixed income.
Glossary
Bull Market
A financial market of a certain group of securities in which prices are rising or are expected to rise. The term "bull market" is most often used in respect to the stock market, but really can be applied to anything that is traded, such as bonds, currencies, commodities, etc.
Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. Of course, no bull market can last forever, and sooner or later a bear market (in which prices fall) will come. It's tough if not impossible to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation can sometimes play a large (if not dominant) role in the markets. The extreme on the high end is a stock-market bubble, and on the low end a crash.
The use of "bull" and "bear" to describe markets comes from the way in which each animal attacks its opponents. That is, a bull thrusts its horns up into the air, and a bear swipes its paws down. These actions are metaphors for the movement of a market: if the trend is up, it is considered a bull market. And if the trend is down, it is considered a bear market.
Bear Market
A market condition in which the prices of securities are falling or are expected to fall. Although figures can vary, a downturn of 15-20% or more in multiple indexes (Dow or S&P 500) is considered an entry into a bear market.
When you see a bear what do you do? Tuck in your arms and play dead! Fighting back can be extremely dangerous. It is quite difficult for an investor to make stellar gains during a bear market, unless he or she is a short seller.
Mortgage
A debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses wishing to make large value purchases of real estate without paying the entire value of the purchase up front.
Mortgages are also known as liens against property, or claims on property.
In a residential mortgage, a homebuyer pledges his or her house to the bank. The bank has a claim on the house should the homebuyer default on paying his or her mortgage. In the case of a foreclosure, the bank may evict the home's tenants and sell the house, using the income from the sale to clear the mortgage debt.
Coupon
The interest rate stated on a bond when it's issued. The coupon is typically paid semiannually.
This is also referred to as the "coupon rate" or "coupon percent rate".
For example, a Rs.1,000 bond with a coupon of 7% will pay Rs.70 a year.
It is called a "coupon" because some bonds literally have coupons attached to them. Holders receive interest by stripping off the coupons and redeeming them. This is less common today as more records are kept electronically.
Maturity Date
The date on which the principal amount of a note, draft, acceptance bond or other debt instrument becomes due and is repaid to the investor and interest payments stop. It is also the termination or due date on which an installment loan must be paid in full.
The maturity date tells you when to expect to get your principal back and how long to expect to receive interest payments. However, it is important to note that some debt instruments, such as fixed-income securities, are "callable", which means that the issuer of the debt is able to pay back the principal at any time. Thus, investors should inquire, before buying any fixed-income securities, whether the bond is callable or not.
Debt
An amount of money borrowed and owed by one party to another.
Bonds, loans and commercial paper are all examples of debt.
Equity
1. Stock or any other security representing an ownership interest.
2. On the balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Also referred to as "shareholder's equity".
3. In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage.
4. In the context of real estate, the difference between the current market value of the property and the amount the owner still owes on the mortgage. Thus, it is the amount, if any, the owner would receive after selling a property and paying off the mortgage.
Equity is a term whose meaning depends very much on the context. In general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner's equity since he or she can readily sell the items for cash. Stocks are equity because they represent ownership of a company, whereas bonds are classified as debt because they represent an obligation to pay and not ownership of assets.
Voting Right
The right of a stockholder to vote on matters of corporate policy as well as on who is to compose the board of directors.
Most voting involves decisions on issuing securities, initiating stock splits, and making substantial changes in the corporation's operations.
Creditor
An entity (person or institution) that extends credit by giving another entity permission to borrow money if it is paid back at a later date. Creditors can be classified as either "personal" or "real". Those people who loan money to friends or family are personal creditors. Real creditors (i.e. a bank or finance company) have legal contracts with the borrower granting the lender the right to claim any of the debtor's real assets (e.g. real estate or car) if he or she fails to pay back the loan.
When creditors are notified of bankruptcy proceedings, they have a couple of options with respect to their claim against the debtor:
1. They can share in any distribution from the bankruptcy estate according to the priority of their claim. Most unsecured, non-wage claims come low on the priority list.
2. They can take the debtor to court and challenge a debtor's discharge (the right not to pay back) due to bankruptcy protection.
Bankruptcy
The state of a person or firm unable to repay debts.
If the bankrupt entity is a firm, the ownership of the firm's assets is transferred from the stockholders to the bondholders. Shareholders are the last people to get paid if a company goes bankrupt. Secure creditors always get first grabs at the proceeds from liquidation.
Bond Basics: Characteristics
Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.
Face Value/Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of Rs 1,000, but this amount can be much greater for government bonds.
What confuses many people is that the par value is not the price of the bond. A bond's price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.
As previously mentioned, most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is Rs 1,000, then it'll pay Rs 100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.
You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.
Maturity
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.
Issuer
The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return tradeoff in action.
The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings.
Bond Rating
Grade
Risk
Moody's
S&P/ Fitch
Aaa
AAA
Investment
Highest Quality
Aa
AA
Investment
High Quality
A
A
Investment
Strong
Baa
BBB
Investment
Medium Grade
Ba, B
BB, B
Junk
Speculative
Caa/Ca/C
CCC/CC/C
Junk
Highly Speculative
C
D
Junk
In Default
Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.
Yield, Price And Other Confusion
Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact, many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any other publicly-traded security. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate - sometimes dramatically. We'll get to how price changes in a bit. First, we need to introduce the concept of yield.
Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its Rs 1,000 par value, the yield is 10% (Rs 100/Rs 1,000). Pretty simple stuff. But if the price goes down to Rs 800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed Rs 100 on an asset that is worth Rs 800 (Rs 100/Rs 800). Conversely, if the bond goes up in price to Rs 1,200, the yield shrinks to 8.33% (Rs 100/Rs 1,200).
Yield To Maturity
Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).
Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.
Putting It All Together: The Link Between Price And Yield
The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related.
Here's a commonly asked question: How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay Rs 800 for the Rs 1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
Price In The Market
So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.
Blue-Chip Stock
Stock of a well-established and financially sound company that has demonstrated its ability to pay dividends in both good and bad times.
These stocks are usually less risky than other stocks. The stock price of a blue chip usually closely follows the S&P 500.
Yield
1. In general, yield is the annual rate of return for any investment and is expressed as a percentage.
2. With stocks, yield can refer to the rate of income generated from a stock in the form of regular dividends. This is often represented in percentage form, calculated as the annual dividend payments divided by the stock's current share price.
3. With bonds, yield is the effective rate of interest paid on a bond, calculated by the coupon rate divided by the bond's market price:
Introduction
The first thing that comes to most people's minds when they think of investing is the stock market. After all, stocks are exciting. The swings in the market are scrutinized in the newspapers and even covered by local evening newscasts. Stories of investors gaining great wealth in the stock market are common.
Bonds, on the other hand, don't have the same sex appeal. The lingo seems arcane and confusing to the average person. Plus, bonds are much more boring - especially during raging bull markets, when they seem to offer an insignificant return compared to stocks.
However, all it takes is a bear market to remind investors of the virtues of a bond's safety and stability. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds.
.
What Are Bonds?
Have you ever borrowed money? Of course you have! Whether we hit our parents up for a few bucks to buy candy as children or asked the bank for a mortgage, most of us have borrowed money at some point in our lives.
Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).
Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity.
For example, say you buy a bond with a face value of Rs.1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of Rs.80 (Rs.1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of Rs.40 a year for 10 years. When the bond matures after a decade, you'll get your Rs.1,000 back.
Debt Versus Equity
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest.
To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.
Why Bother With Bonds?
It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true:
1) Retirement - The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
2) Shorter time horizons - Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.
These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of fixed income.
Glossary
Bull Market
A financial market of a certain group of securities in which prices are rising or are expected to rise. The term "bull market" is most often used in respect to the stock market, but really can be applied to anything that is traded, such as bonds, currencies, commodities, etc.
Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. Of course, no bull market can last forever, and sooner or later a bear market (in which prices fall) will come. It's tough if not impossible to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation can sometimes play a large (if not dominant) role in the markets. The extreme on the high end is a stock-market bubble, and on the low end a crash.
The use of "bull" and "bear" to describe markets comes from the way in which each animal attacks its opponents. That is, a bull thrusts its horns up into the air, and a bear swipes its paws down. These actions are metaphors for the movement of a market: if the trend is up, it is considered a bull market. And if the trend is down, it is considered a bear market.
Bear Market
A market condition in which the prices of securities are falling or are expected to fall. Although figures can vary, a downturn of 15-20% or more in multiple indexes (Dow or S&P 500) is considered an entry into a bear market.
When you see a bear what do you do? Tuck in your arms and play dead! Fighting back can be extremely dangerous. It is quite difficult for an investor to make stellar gains during a bear market, unless he or she is a short seller.
Mortgage
A debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses wishing to make large value purchases of real estate without paying the entire value of the purchase up front.
Mortgages are also known as liens against property, or claims on property.
In a residential mortgage, a homebuyer pledges his or her house to the bank. The bank has a claim on the house should the homebuyer default on paying his or her mortgage. In the case of a foreclosure, the bank may evict the home's tenants and sell the house, using the income from the sale to clear the mortgage debt.
Coupon
The interest rate stated on a bond when it's issued. The coupon is typically paid semiannually.
This is also referred to as the "coupon rate" or "coupon percent rate".
For example, a Rs.1,000 bond with a coupon of 7% will pay Rs.70 a year.
It is called a "coupon" because some bonds literally have coupons attached to them. Holders receive interest by stripping off the coupons and redeeming them. This is less common today as more records are kept electronically.
Maturity Date
The date on which the principal amount of a note, draft, acceptance bond or other debt instrument becomes due and is repaid to the investor and interest payments stop. It is also the termination or due date on which an installment loan must be paid in full.
The maturity date tells you when to expect to get your principal back and how long to expect to receive interest payments. However, it is important to note that some debt instruments, such as fixed-income securities, are "callable", which means that the issuer of the debt is able to pay back the principal at any time. Thus, investors should inquire, before buying any fixed-income securities, whether the bond is callable or not.
Debt
An amount of money borrowed and owed by one party to another.
Bonds, loans and commercial paper are all examples of debt.
Equity
1. Stock or any other security representing an ownership interest.
2. On the balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Also referred to as "shareholder's equity".
3. In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage.
4. In the context of real estate, the difference between the current market value of the property and the amount the owner still owes on the mortgage. Thus, it is the amount, if any, the owner would receive after selling a property and paying off the mortgage.
Equity is a term whose meaning depends very much on the context. In general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner's equity since he or she can readily sell the items for cash. Stocks are equity because they represent ownership of a company, whereas bonds are classified as debt because they represent an obligation to pay and not ownership of assets.
Voting Right
The right of a stockholder to vote on matters of corporate policy as well as on who is to compose the board of directors.
Most voting involves decisions on issuing securities, initiating stock splits, and making substantial changes in the corporation's operations.
Creditor
An entity (person or institution) that extends credit by giving another entity permission to borrow money if it is paid back at a later date. Creditors can be classified as either "personal" or "real". Those people who loan money to friends or family are personal creditors. Real creditors (i.e. a bank or finance company) have legal contracts with the borrower granting the lender the right to claim any of the debtor's real assets (e.g. real estate or car) if he or she fails to pay back the loan.
When creditors are notified of bankruptcy proceedings, they have a couple of options with respect to their claim against the debtor:
1. They can share in any distribution from the bankruptcy estate according to the priority of their claim. Most unsecured, non-wage claims come low on the priority list.
2. They can take the debtor to court and challenge a debtor's discharge (the right not to pay back) due to bankruptcy protection.
Bankruptcy
The state of a person or firm unable to repay debts.
If the bankrupt entity is a firm, the ownership of the firm's assets is transferred from the stockholders to the bondholders. Shareholders are the last people to get paid if a company goes bankrupt. Secure creditors always get first grabs at the proceeds from liquidation.
Bond Basics: Characteristics
Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.
Face Value/Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of Rs 1,000, but this amount can be much greater for government bonds.
What confuses many people is that the par value is not the price of the bond. A bond's price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.
As previously mentioned, most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is Rs 1,000, then it'll pay Rs 100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.
You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.
Maturity
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.
Issuer
The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return tradeoff in action.
The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings.
Bond Rating
Grade
Risk
Moody's
S&P/ Fitch
Aaa
AAA
Investment
Highest Quality
Aa
AA
Investment
High Quality
A
A
Investment
Strong
Baa
BBB
Investment
Medium Grade
Ba, B
BB, B
Junk
Speculative
Caa/Ca/C
CCC/CC/C
Junk
Highly Speculative
C
D
Junk
In Default
Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.
Yield, Price And Other Confusion
Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact, many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any other publicly-traded security. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate - sometimes dramatically. We'll get to how price changes in a bit. First, we need to introduce the concept of yield.
Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its Rs 1,000 par value, the yield is 10% (Rs 100/Rs 1,000). Pretty simple stuff. But if the price goes down to Rs 800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed Rs 100 on an asset that is worth Rs 800 (Rs 100/Rs 800). Conversely, if the bond goes up in price to Rs 1,200, the yield shrinks to 8.33% (Rs 100/Rs 1,200).
Yield To Maturity
Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).
Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.
Putting It All Together: The Link Between Price And Yield
The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related.
Here's a commonly asked question: How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay Rs 800 for the Rs 1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
Price In The Market
So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.
Blue-Chip Stock
Stock of a well-established and financially sound company that has demonstrated its ability to pay dividends in both good and bad times.
These stocks are usually less risky than other stocks. The stock price of a blue chip usually closely follows the S&P 500.
Yield
1. In general, yield is the annual rate of return for any investment and is expressed as a percentage.
2. With stocks, yield can refer to the rate of income generated from a stock in the form of regular dividends. This is often represented in percentage form, calculated as the annual dividend payments divided by the stock's current share price.
3. With bonds, yield is the effective rate of interest paid on a bond, calculated by the coupon rate divided by the bond's market price: