An introduction to bonds
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An Introduction to Bonds. Tina Horvath. What is a Bond?. Debt instrument: When one purchases a bond, one essentially lends an organization such as the government or a corporation a specified amount of money which the borrower agrees to repay at a designated time. Why buy a bond?

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What is a bond
What is a Bond?

  • Debt instrument: When one purchases a bond, one essentially lends an organization such as the government or a corporation a specified amount of money which the borrower agrees to repay at a designated time.

  • Why buy a bond?

    • In exchange for permission to borrow money from the lender, the organization agrees to pay annual interest payments on the amount borrowed.

  • Components:

    • principal - face value of the bond (typically $1000)

    • coupon - rate of interest

    • maturity - time till issuer will repay borrower


Different types of bonds
Different Types of Bonds

  • Corporate

  • Government (Treasury)

  • Municipal


Corporate bonds
Corporate Bonds

  • Corporate bonds are issued so that companies can finance expansion or raise funds for other expenses.

  • Senior debt - bonds that are backed by specific assets of the company.

  • Debenture - a bond whose issue is secured simply by the promise of the company to repay the amount borrowed.

  • Default Risk (Ratings)

    • Standard & Poor: AAA = good credit, CCC = poor standing

    • Moody: Aaa = good credit, Caa = poor standing

  • Special cases:

    • “junk bonds” - bonds with high default rating (CCC, Caa or worse)

    • convertible bonds - bonds that can be exchanged for other securities


Government bonds
Government Bonds

  • Government, or Treasury bonds, are especially noted for their lack of risk since they are backed by the US government.

    • bill - maturity of a year or less

    • note - maturity of 1-10 years

    • bond - maturity of 10+ years

  • STRIPS - Separate Trading Registered Interest and Principal Securities, or STRIPS, can be split up into separate interest and principal payments, with each payment trading as a separate security. Example: zero coupon bonds

  • The Federal Reserve retains some control over the bond market by

    • open-market operations: buying or selling US Treasuries in order to control the money supply

    • changing the discount rate: raising or lowering the rate which in turn raises or lowers general interest rates

    • setting reserve requirements: increasing reserves and thereby raising interest rates or decreasing reserves and thereby decreasing rates


Municipal bonds
Municipal Bonds

  • Municipal bonds are state and local government bonds.

  • Tax free, not subject to federal taxes

  • Two types of municipal bonds:

    • general obligation bonds - funded by property taxes, sales taxes, and income tax

    • revenue bonds - funded by revenue from a particular project; e.g., a government issues a revenue bond in order to build a turnpike and repays these bonds with the tolls collected.


Yields
Yields

  • Coupon yield: the interest paid on the principal based on the coupon rate.

  • Current yield: yield based on interest payments with respect to the purchase price of the bond (discount, premium).

  • Yield to maturity (YTM): estimates the total amount that one can earn over the total life of the bond.

    • YTM = coupon + prorated discount or premium (face value + purchase price) / 2


What determines bond prices
What Determines Bond Prices?

  • Current market interest rates: Bond prices tend to increase when interest rates fall and decrease when rates rise.

  • Inflation: High inflation will devalue a bond.

  • Liquidity: The ease and cost of trading a particular bond will affect the price.

  • Political risk: People tend not to invest when the government seems unstable.



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