Definition of 'Bond'¶
A bond is a debt investment where an investor loans money to an entity (corporate or governmental) which borrows the funds for a defined period at a fixed interest rate. Bonds are commonly used by companies, municipalities, states, and sovereign governments to finance various projects and activities.
Features of Bonds¶
- A Sealed Agreement: Bonds are formalized through a legal contract specifying the terms of the debt agreement.
- Repayment of Principal: The principal amount borrowed is repaid to the bondholder at the maturity of the bond.
- Specified Time Period: The bond has a set duration until maturity, during which interest payments are made and principal repayment is due at the end.
- Interest Payment: Bonds typically involve periodic payments of interest, known as coupon payments.
- Call Option: Some bonds include a call feature, allowing the issuer to repay the bond before its maturity date under specific conditions.
Types of Bonds¶
- Government Bonds: Issued by national governments, these bonds are often considered low-risk investments.
- Municipal Bonds: Issued by states, cities, or other local government entities, often offering tax-free interest income.
- Corporate Bonds: Issued by companies; these are higher risk than government bonds but usually offer higher interest rates.
- Zero-Coupon Bonds: Do not pay periodic interest but are issued at a discount to their face value, creating a profit at maturity when the face value is repaid.
Bond Cash Flows¶
The cash flows of a bond consist of periodic coupon payments and the repayment of the principal at maturity. The present value of these expected cash flows determines the bond's current market value.
Coupon Types¶
- Annual Coupons: Paid once a year.
- Semi-annual Coupons: Paid twice a year, each payment being half the annual coupon rate.
- Zero-Coupon Bonds: No periodic interest payments. The bond is purchased at a discount, and all returns are realized at maturity when the face value is paid.
Calculating Present Value¶
The value of a bond today is the present value (PV) of its expected cash flows, which include periodic coupon payments and the principal repayment at maturity. The calculation typically uses the yield to maturity (YTM) as the discount rate, reflecting the bond's total yield if held to maturity.
\(Value\ today = PV\ of\ expected\ cash\ flows\)
Conclusion¶
Understanding the features and types of bonds, along with how their cash flows are structured and valued, is crucial for investors considering bonds as part of their investment portfolios. This knowledge aids in assessing risks, potential returns, and suitability in relation to an investor's overall financial strategy.
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