A bond is a fixed income investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.
So let’s take an example of a 10-year bond issued on 1st Jan 2010 INR 1000 at 10%.
So to put in simpler terms, a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest.
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date). The interest rate, called the coupon rate or payment, is the return that bondholders earn for loaning their funds to the issuer.
The issuance price of a bond is typically set at par, usually Rs. 100 or Rs. 1,000 Face Value per individual bond. The actual market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.
Most bonds share some common basic characteristics including:
Two features of a bond – credit quality and duration – are the principal determinants of a bond's interest rate. If the issuer has a poor credit rating, the risk of default is greater and these bonds will tend to trade a discount. In addition, bonds with a high default risk, such as junk bonds, have higher interest rates than stable bonds, such as government bonds.
Credit ratings are calculated and issued by credit rating agencies. Bond maturities can range from a day or less to more than 30 years. The longer the bond maturity, or duration, the greater the chances of adverse effects. Longer-dated bonds also tend to have lower liquidity. Because of these attributes, bonds with a longer time to maturity typically command a higher interest rate.
When considering the riskiness of bond portfolios, investors typically consider the duration (price sensitivity to changes in interest rates) and convexity (curvature of duration).
There are three main categories of bonds.
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The bond is essentially a composition of a series of coupon payments (interest) and a final maturity amount. Hence the price of the bond is a sum of:
So how do we calculate bond price? It is not so complex as it looks.
Let’s take the formula for compound interest:
Amount = Principal (1 + r/100)t
r = interest rate in %
t = time in years
or Principal = Amount / (1 + r/100)t
Now applying this to discount the coupon paid in each year and the redemption amount we have the following table:
Setting the discount rate at 10% (this would be the prevailing rate currently since the issuer is raising funds at this time). The price of the bond as per calculation is Rs. 1000 (same as what we paid for it).
Thus, buying a bond is like giving out a loan and you can expect a fixed income return till the time of maturity. Every bond is characterised by its face value, maturity period, interest rate, and issuer. Buying a bond diversifies your investment portfolio.