Bonds are I.O.U. (“I Owe U”), debt related securities issued by government or companies. The issuer is the borrower and the bond buyer is the lender. The borrower promises to pay back the principal amount at a specific date. To compensate the lender, the borrower has to pay a fixed interest rate during the loan period. Bonds are usually long term, 10 or 20 years are common.
Bonds vs Stocks
The main difference between bonds and stocks is that the latter would grant the investor a part ownership of the issuing company. Bond holders on the other hand do not have this right. However, in a case of bankruptcy of the company, bond holders have the precedence over share holders to be paid off after liquidation of assets.
Bonds can have collaterals like real estate or company equipment as backing. If the loan is defaulted, these collaterals can be liquidated to pay back bond holders. These are secured bonds and seemed to be safer. However, we learned from the recent U.S. sub-prime meltdown that even bonds with mortgage backing can face troubles too. Unsecured bonds are also known as debentures, where there are no collaterals backing and are issued based on good reputation of the companies or government.
Interest rates and bond price
Economics will tell you that interest rate and bond price move in opposite direction. When interest rate increases, bond price decreases. The reason is due to the fixed interest rate the bond issuer has to pay even though market interest rate changes. For example, a bond issuer promised 5% fixed interest rate based on the market interest rate of 5% at that point in time. Investor A purchased the bond and after a period of time, the market interest rate increases to 8% but the bond interest payout remain at 5%. Investor B wants to invest in bond – he would pay less for Investor A’s bond because he can buy a new bond that gives him an 8% return instead of 5%. Thus, the change in bond price in relation to market interest rate is to accommodate and adjust to such fluctuations. Bond issuers are not obliged to redeem bonds before maturity but bond holders can sell their holdings in the open market.
Coupon is equivalent to interest rate. Zero-coupon bonds are bonds that do not pay interests until the bond reach maturity. These bonds are sold at a discount upfront and redeemed at full amount at maturity.
Bond yield
Bond yield is the percentage of return an investor expect when he purchases the bond so as to make a comparison across securities. To calculate, divide the the annual interest payment by the bond price. For example, bond yield of a bond worth $1000 and paying annual interest of $50 is 5% (50/1000 x 100%). Previously, we understand that bond price will change as interest rate fluctuates while the annual interest payment will remain constant. Thus, if bond price drops to $800, the bond yield will be $50/$800 x 100% = 6.25%.
You may also like:
Discover the Secrets of Singapore Trading Gurus!
Interviews with Singapore stocks, forex, futures and options traders and trainers! This book is written for you:
- learn how professionals trade
- discover their strategies, money management and approach to the markets
- understand their stories and motivation behind trading
- know your trainers before attending their courses
{ 3 trackbacks }