4 Basic Mechanics That Explain How Bonds Work

Issuers raise capital by selling bonds, providing fixed interest payments and returning face value upon maturity.

Issuance of Bonds

Government Bonds

Governments issue bonds to raise money to finance public projects such as infrastructure, education, or healthcare. These bonds are issued and sold to investors who receive a repayment of their principal at a fixed maturity date and receive interest at regular intervals. The U.S. Treasury Department issues a variety of bonds that have different interest rates (e.g., Treasury bills, notes, and bonds) and different maturities.

Corporate Bonds

Companies will issue bonds to pay for expansion, research and development, or other major capital investments. This is in contrast to government bonds, which have a much higher risk profile than government bonds because more interest is included. Draft Example – A tech company might issue bonds to finance a new factory. Investors buy the bonds and then earn money by lending money to the company in exchange for interest payments over time, with the principal returned in full when the bond matures.

Municipal Bonds

Issued by cities or other local governments to pay for public works such as schools, hospitals, or highways. Municipal bonds are attractive to investors because the interest income is almost always exempt from federal income taxes, and if the investor lives in the state that issued the bond, the income may also be exempt from state and local taxes. For example, a city might sell municipal bonds to raise money to build a new library. Such tax benefits make municipal bonds attractive to investors seeking income.

Bond Ratings and Risk Assessment.

Agencies such as Standard & Poor’s, Moody’s and Fitch assign credit ratings to bond issuers. These ratings indicate the likelihood of repayment as well as the creditworthiness of the issuer. Investment grade bonds (AAA to AA) are higher rated bonds and are considered safer investments, while non-investment grade bonds (BB and below) are speculative and considered risky. Ratings help issuers obtain financing within a specific interest rate. An A-rated corporate bond might have an interest rate of 3%, while a B-rated bond might have a yield of 7% to compensate for the increased risk.

Issuance Process

Issuing a bond involves several steps:

  1. Planning and Approvals: The issuer estimates the funds needed and seeks regulatory approval.
  2. Underwriting: Investment banks underwrite the bond issuance and have an opinion on the terms and pricing of the bond.
  3. Marketing: Market the bond to potential investors through road shows and presentations.
  4. Sales: The bonds are then sold to investors through a public offering or private placement
  5. Settlement: On this day, the funds from the bond sales are transferred to the issuer and the bonds are delivered to investors.

Understanding Bond Pricing

Par Value

Par value or face value is the amount that the bondholder will receive when the bond matures. Bonds are usually sold in increments of $1,000 in face value. It provides an important reference as a basis for calculating interest payments and bond prices in the secondary market.

Coupon Rate and Payments

The interest rate that the bond issuer promises to the bondholder. For example, if the bond has a par value of $1,000 and an annual coupon rate of 5%, the bondholder will receive $50 in interest every year in this case. This has a better fixed interest payment, which is one of the reasons why investors find it more attractive.

Market Price and Yield

A bond is a financial instrument in the form of a certificate that allows the issuer to borrow money at a predetermined interest rate for a specific period of time. If interest rates are rising, it means that long-term bond prices are falling and vice versa. For example, let’s say there is a 5% coupon bond that is trading at $950 – its yield will be higher than 5% because the bondholder will receive $50 in interest every year from an investment that only costs $950.

Yield to Maturity (YTM)

YTM is a more comprehensive representation of a bond’s return than current yield, taking into account the bond’s current market price, par value, coupon rate, and time to maturity. YTM is a number displayed as an annual percentage rate. If you buy a 5-year bond with a par value of $1,000 and a coupon rate of 5% for $900, your YTM is greater than the coupon rate because you will receive annual interest payments in addition to the $100 difference between the purchase price and the par value at maturity.

Premium and Discount Bonds

Bonds may trade above par value (premium) or below par value (discount). If a bond is trading above its par value, it is called a premium bond, and if it is trading below its par value, it is called a discount bond. For example, if interest rates have fallen since the bond was originally issued, the market price of the bond may be above par simply because the bond’s original coupon payment has become more attractive. Conversely, in the latter case, it may trade below par value.

Pricing a Bond

Bond with a par value of $1,000, coupon rate: 6%, maturity: 10 years Subsequent factors in pricing the bond return Considering the market interest rate of 4%, the bond will be worth more than the par value because the coupon rate is better than the current interest rate. All of these factors can be determined with a financial calculator or calculated using formulas, so you will know the price of the bond.

Interest Payments and Coupon Rates

Coupon Rate Definition

The coupon rate is the annualized interest that a bond issuer pays its holders. It is a discount rate expressed as a percentage of the face value of the bond. For example, a $1,000 face value bond with a 5% coupon rate will earn $50 in interest each year. The larger this fixed fee is, the more important it is to investors seeking steady income.

Fixed vs. Variable Coupon Rates

Fixed Rate: The interest payments you receive on a bond will be calculated as a fixed percentage throughout the life of the bond, providing clarity and stability to investors. A 10-year bond with a fixed coupon rate of 4% will pay $40 each year, regardless of how the market moves.

Variable or Floating Rate Bonds: The coupon rates on these bonds reset periodically based on a benchmark rate, such as LIBOR or the Federal Funds Rate. Also, as general interest rates rise, these bonds can pay more in interest, which can be a hedge against inflation. For example, if a bond’s coupon rate is based on 1% of LIBOR, its payments will change over time with LIBOR.

Payment Frequency

Depending on the terms of the bond, a bond can pay interest annually, semi-annually, quarterly, or monthly. In the United States, semi-annual payments are the norm. For this reason, $300 would be better off earning 3% every 6 months, reducing the impact of the bond’s duration (e.g., a 6% coupon rate per year) to its component, the 3% coupon rate paid semi-annually. Such a payment schedule affects bond cash flows, making the bond attractive to all types of investors.

Market Interest Rate Impact

The market interest rate environment affects bond prices and yields. As market interest rates rise, existing bonds with lower coupon rates become less attractive, causing their prices to fall. On the other hand, as market interest rates fall, existing bonds with higher coupon rates rise in value, so their prices rise.

If the interest rate on the new bond is 3% and above 5%, your bond value will appreciate because your bond offers a higher return than the newly issued bond.

Tax Considerations

Bond interest income may be subject to federal, state, and local taxes. Yes, but some bonds (such as municipal bonds) offer tax deductions. Municipal bond income is exempt from federal income taxes and is also exempt from state and local taxes if the bondholder lives in the state that issued the bond. Tax-free status is what makes municipal bonds so attractive to wealthy investors.

Accrued Interest

Investors who buy bonds between interest payment dates are required to reimburse the seller for any interest the bond accrues. It reimburses the seller for the interest earned before the agreed-upon sale date. When you buy a bond in the middle of an interest payment period, you pay the seller the interest for that half period, which is added to the bond’s purchase price.

Bond Redemption and Maturity

Redemption at maturity

A bond redemption occurs when the issuer repays the bondholder the face value of the bond at the end of the bond’s term. This event is called the bond’s maturity. For example, for a 10-year, $1,000 bond, you will receive $1,000 from the issuer after 10 years. This is a guaranteed repayment, unless there is a material default.

Applicable early redemption and call provisions

Redemption provisions: Bonds may have redemption provisions that allow the issuer to redeem the bond before it matures. When interest rates fall, the issuer can (and usually does) redeem the bond to refinance at a lower rate. For example, if a company sells bonds at 6%, but market interest rates subsequently fall to 4%, it can exchange its outstanding bonds for new bonds issued at a lower rate.

When a bond is redeemed, the issuer usually pays a premium (usually above par value), often called a redemption premium, for it. This premium serves as compensation to the bondholder for the loss of future interest payments. For example, a bond with a face value of $1,000 might be redeemed for $1,050.

Sinking Fund

A sinking fund is a cash reserve that the issuer sets aside to meet any redemption requests. This reduces the risk of default to some extent, making the bond more attractive to investors. For example, a business could deposit a portion of its earnings into a sinking fund each year to repay a $10 million bond issue in 10 years.

Partial Redemption

When an issuer redeems only part of a bond before maturity, it is called a partial redemption. This can be done randomly or on a schedule. For example, for a $20 million bond issue, $5 million could be redeemed each year, year by year, until the issue amount is repaid.

Redemption and Maturity Dates

This would include the maturity date of the bond and the possible redemption dates. Knowing these dates helps investors maintain their portfolio and reinvestment strategy. For example, if you know your bond will mature in five years, you can plan to reinvest the principal at maturity.

How a Call Feature Affects Bond Prices

Bonds with call provisions or sinking funds may be priced differently than bonds that lack these features. They determine the yield and market value of a bond. For example, callable bonds typically have higher yields to help offset call risk, while bonds with sinking funds may trade at a premium due to reduced default risk.

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