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Bonds are fixed-income investments where investors lend money to issuers—like governments or corporations—in exchange for regular interest payments (coupons) and the return of the principal at maturity.
Types of Bonds
Government Bonds: These are considered one of the safest investments, as they’re backed by the full faith and credit of the issuing government. Examples include:
∙ U.S. Treasury bonds (T-bills, T-notes, T-bonds)
∙ Canadian federal bonds
∙ British government bonds (Gilts)
Municipal Bonds: Issued by local governments to fund public projects such as infrastructure development, education, and healthcare. These bonds often offer tax benefits, such as:
∙ Interest income can be exempt from state or local taxes
∙ Capital gains can be tax-free
Corporate Bonds: Issued by companies to raise capital for various purposes, such as expanding their business or refinancing debt. Corporate bonds can be further categorized into:
Investment-grade: These bonds have a lower risk level and typically offer lower returns (e.g., 3-6% interest). Examples include:
∙ Apple bonds
∙ Microsoft bonds
High-yield bonds: These bonds carry a higher risk and offer higher returns (e.g., 7-10% interest) to compensate for the increased risk. Sometimes these bonds are referred to as “Junk Bonds” due to the risk taken by the investor. Examples include:
∙ Bonds issued by companies with low credit ratings.
Agency Bonds: Issued by government-affiliated entities, such as Fannie Mae and Freddie Mac, which fund mortgage lending and other housing-related projects.
Zero-Coupon Bonds: Sold at a discount from their face value, these bonds pay no interest during the term of the bond but mature at full face value. Examples include:
∙ U.S. Treasury zero-coupon bonds
∙ Corporate zero-coupon bonds
Convertible Bonds: These bonds can be converted into company stock under certain conditions, such as when the company’s stock price reaches a certain level or if the holder chooses to convert them.
How Bonds Work
Face Value (Par Value): The amount repaid at maturity, which is also known as the par value.
Coupon Rate: The annual interest paid to bondholders, expressed as a percentage of the face value.
Maturity Date: The date when the principal is returned to the bondholder.
Bond prices fluctuate inversely with market interest rates and rising rates lower existing bond prices. The yield on a bond represents the return an investor can expect from the investment, which includes:
∙ The coupon rate (interest paid annually)
∙ The change in price due to changes in market interest rates
When buying a new bond, investors pay face value. If they sell before maturity, they’ll receive less than the face value. When selling an existing bond, the seller receives a portion of the face value, and the difference is called the coupon payment.
Examples on Calculating Bond Values
Suppose you buy a $1,000 U.S. Treasury bond with a 5% annual interest rate (coupon rate) and the interest rate remains constant over the 10 years. At maturity, you’ll receive $1,500 ($1,000 Face value + (5% x 1000 x 10yrs).
Now let’s say the market interest rate rises to 7.5% after you purchase the bond. The new bond price will be lower than $1,000 due to the higher yield. To calculate the new bond price:
∙ Face value (F): $1,000
∙ Coupon rate: 5%
∙ Market interest rate (r): 7.5%
∙ Time (t): 20 years
Bond Price = Coupon payment x (adjusted rate) + New Face Value
Coupon payment = 1000 x 5% = 50
B.P = 50 x [1 – (1 / (1+r)^t) /r] + [F / (1+r)^t ]
B.P = 50 x [1 – (1 / (1+0.075)^20) / 0.075] + [1000 / (1+0.075)^20]
B.P = 50 x [1 – (1 / 4.2478511002) / 0.075] + [1000 / 4.278511002]
B.P = 50 x [0.764587 / 0.075] + 233.7261723839
B.P = 50 x 10.1944933333 + 233.7261423839
B.P = 509.7246666667 + 233.726142839
Bond Price = $743.45 after 20 years of a 7.5% interest rate
In this example, the bond price has decreased due to the higher market interest rate over the 20-year term. Understanding the types of bonds and their characteristics can help you make informed investment decisions. Bonds offer relatively low risk compared to other investments, but returns may be lower than those from equities or other assets depending on market conditions. Bond pricing and yields are influenced by changes in the market interest rates, which can affect bond prices and investor returns upon maturity.
