Bonds

Most of us would have heard about bonds at some point in our lives, people use several terms like coupon, maturity, yield, duration and market value while talking about bonds. But what do these terms mean? and how do you know whether or not you should buy a bond at a particular price?

Before we dive headfirst into analysis of bond value, let us take a step back and understand what bonds really are. Bonds are essentially I.O.Us, which is finance jargon for a declaration of debt (derived from the phrase "I owe you"). An entity issues bonds when it seeks to raise money, this entity can be a government or even a company. When a person buys a bond, he doesn't invest in the entity but rather lends the entity some money, for example, the government might need to raise money for a new highway, or for military equipment it would do so by issuing bonds.

Bonds are like a double edged sword for the issuer that provide vital long term source of capital but can also lead to bankruptcy if the company is unable to overcome the debt. All bonds have a certain face value which is the amount of money that the bond holder receives at maturity, it is also called par value. All bonds also have a coupon rate which is the interest that the issuer pays the bondholder on the underlying loan. The coupon rate is decided based on the relative risk of the bond, for example, government bonds are considered to be safe as the government never defaults on its debts hence they have low coupon rates as compared to the bonds issued by a relatively new private company which has a high chance of loan default and hence has to offer a higher coupon rate to make its bond attractive. Bond rating agencies like Standard and Poor's Global Ratings, Moody's Investors Service, and Fitch Ratings aid the investors gauge the relative risk of bonds.

When an investor buys the bond from the primary market, i.e. directly from the issuer, he/she pays the issuer the face value. The issuer will now keep paying the investor the coupon till the bond reaches maturity upon which the entire face value will be returned. The maturity can be anywhere between a few months to a hundred years (such bonds are called perpetuities) .

But the primary market is not the only way to buy a bond, bonds can be resold on the secondary market and here the price of a bond is determined by yield or more precisely by the yield to maturity (YTM). Yield is the return an investor receives on a bond, one can imagine it to be equivalent to the interest rate that one might get by investing in a bank (but should note the difference). The yield accounts for the time value of money and compounding interest payments. The yield is used to evaluate a bond and if the YTM is greater than the coupon rate the bond is traded at a discount (below face value) and if YTM is less than the coupon rate the bond is traded at a premium ( above face value). The exact market value of a bond can be calculated by finding the present value of all future coupons till maturity and the face value.