Bonds: Financial Meaning and How They Are Priced
What are bonds?
Bonds are a type of security that represents debt, and they are issued by companies, governments and other entities in order to raise capital. Bonds are typically offered at a face value, and then they are priced according to their interest rate. This means that the price of a bond will be determined by its coupon rate, which is the rate of interest that is paid out on the bond over time.
Bonds are typically issued with a fixed rate of interest, meaning that the rate of interest paid out over the life of the bond will remain the same. This makes them attractive to investors, as they know the exact return they will receive each time they purchase the bond. The coupon rate of a bond is usually paid out semi-annually, although some bonds may pay out interest quarterly, or even annually.
A bond could be seen as an I.O.U (I owe you) between the lender and borrower that outlines all the specifics of the loan and its payments. This type of financial instrument is used by companies, states, and governments to finance their endeavors. People who possess bonds are considered debt holders of the issuer.
The information printed on a bond includes the date when the main loan amount should be repaid to the bondholder and often contains the conditions of the variable or fixed interest payments that the borrower must satisfy.
Who issues bonds?
Bonds are a form of debt where governments and companies can obtain funding for projects such as roads, dams, and schools, or for growth and expansion. As the amount of money needed is often far greater than what banks can provide, public debt markets allow for the funds to be dispersed among thousands of individual investors who can then lend a portion of the required capital. These investors can also sell or buy bonds from other individuals, even after the organization has initially raised the capital.
Types of bonds
Bonds are divided among four primary types sold in the markets. However, we can add foreign bonds that are issued by global corporations and governments.
- Corporate bonds are issued by companies. Companies choose to issue bonds instead of obtaining bank loans as a form of debt financing because the terms that come with bonds are often more advantageous and interest rates are lower.
- Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
- Government bonds such as those issued by the U.S. Treasury, are known as “treasuries.” These can be divided into three categories: “Bills” with up to one year to maturity, “notes” with one to ten years to maturity, and “bonds” with more than ten years to maturity. This type of debt is often referred to as “sovereign debt.”
- Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.
Advantages & disadvantages of bonds
|Interest payments provide income||Lower return compared to stocks|
|The ability to hold the bond until receiving the capital back||Companies might fail to repay the bonds|
|Achieving profit when selling the bond at higher price||Bond yields might fall|
How are bonds priced?
The market prices the bonds based on their individual qualities. Just like any other publicly traded asset, the price of a bond changes on a daily basis, with the observed cost being decided by the supply and demand at that particular moment.
When it comes to pricing a bond, there are a few factors that need to be taken into consideration.
- The first factor is the current market rate. This is the rate of interest which is being paid out on other similar bonds in the marketplace. If the rate of interest on the bond being priced is higher than the current market rate, then the bond will be priced at a premium, meaning that it will cost more than its face value. However, if the rate of interest on the bond being priced is lower than the current market rate, then the bond will be priced at a discount, meaning that it will cost less than its face value.
- The second factor that needs to be taken into consideration when pricing a bond is the creditworthiness of the issuer. If the issuer has a good credit rating, then the bond will be priced at a premium. This is because investors will be more willing to take on the risk of investing in the bond, as they will be confident that they will get their money back. On the other hand, if the issuer has a poor credit rating, then the bond will be priced at a discount. This is because investors will be more reluctant to take on the risk of investing in the bond, as they will be less confident that they will get their money back.
- The final factor that needs to be taken into consideration when pricing a bond is the length of time until the bond matures. If the bond is due to mature soon, then the bond will be priced at a premium. This is because investors will be more willing to take on the risk of investing in the bond, as they know that they will get their money back shortly. On the other hand, if the bond has a long maturity period, then the bond will be priced at a discount. This is because investors will be more reluctant to take on the risk of investing in the bond, as they will be less confident that they will get their money back.
In conclusion, bonds are a type of security that represents debt, and they are priced according to their coupon rate, market rate, creditworthiness of the issuer and the length of time until the bond matures. By understanding how bonds are priced, investors can make more informed decisions when it comes to investing in bonds.