11/30/2023 0 Comments Bond finance definition![]() ![]() Another common term is “par value,” which is simply another way of saying face value. If the bond is trading at 100, it costs $1,000 for every $1,000 of face value and is said to be trading at par. If the bond is trading at 101, it costs $1,010 for every $1,000 of face value and the bond is said to be trading at a premium. For example, if a bond is quoted at 99 in the market, the price is $990 for every $1,000 of face value and the bond is said to be trading at a discount. The easiest way to understand bond prices is to add a zero to the price quoted in the market. In the market, bond prices are quoted as a percent of the bond’s face value. On the other hand, if interest rates rise, older bonds may become less valuable because their coupons are relatively low, and older bonds therefore trade at a “discount.” Understanding bond market prices Investors holding older bonds can charge a “premium” to sell them in the secondary market. When prevailing interest rates fall – notably, rates on government bonds – older bonds of all types become more valuable because they were sold in a higher interest rate environment and therefore have higher coupons. The key to understanding this critical feature of the bond market is to recognize that a bond’s price reflects the value of the income that it provides through its regular coupon interest payments. ![]() Yield is therefore based on the purchase price of the bond as well as the coupon.Ī bond’s price always moves in the opposite direction of its yield, as previously illustrated. Obviously, a bond must have a price at which it can be bought and sold (see “Understanding bond market prices” below for more), and a bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. While some bonds are traded publicly through exchanges, most trade over-the-counter between large broker-dealers acting on their clients’ or their own behalf.Ī bond’s price and yield determine its value in the secondary market. What determines the price of a bond in the open market?īonds can be bought and sold in the “secondary market” after they are issued. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.Įvery bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. In other words, an issuer will pay a higher interest rate for a long-term bond. The additional risk incurred by a longer-maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. ![]() A $1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many more factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period relative to a 5-year period. At the end of five years, the bond reaches maturity and the corporation repays the $1,000 face value to each bondholder.How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. The issuer may decide to sell five-year bonds with an annual coupon of 5%. To set the coupon, the issuer takes into account the prevailing interest rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. The corporation – now referred to as the bond issuer − determines an annual interest rate, known as the coupon, and a time frame within which it will repay the principal, or the $1 million. ![]() In this case, the “face value” of each bond is $1,000. The corporation might decide to sell 1,000 bonds to investors for $1,000 each. Suppose a corporation wants to build a new manufacturing plant for $1 million and decides to issue a bond offering to help pay for the plant. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity. If an investor buys a corporate bond, the investor is lending the corporation money. An investor who buys a government bond is lending the government money. Governments, corporations and municipalities issue bonds when they need capital. A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. ![]()
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