Bonds

What Is a Bond?

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower

(typically corporate or governmental). A bond could be thought of as an I.O.U. between
the lender and borrower that includes the details of the loan and its payments. Bonds are used by
companies, municipalities, states, and sovereign governments to finance projects and
operations. Owners of bonds are debtholders, or creditors, of the issuer.

Bond details include the end date when the principal of the loan is due to be paid to the bond
owner and usually include the terms for variable or fixed interest payments made by the
borrower.

KEY TAKEAWAYS

 Bonds are units of corporate debt issued by companies and securitized as tradeable
assets.
 A bond is referred to as a fixed-income instrument since bonds traditionally paid a fixed
interest rate (coupon) to debtholders. Variable or floating interest rates are also now
quite common.
 Bond prices are inversely correlated with interest rates: when rates go up, bond prices
fall and vice-versa.
 Bonds have maturity dates at which point the principal amount must be paid back in full
or risk default.

The Issuers of Bonds

Governments (at all levels) and corporations commonly use bonds in order to borrow money.
Governments need to fund roads, schools, dams, or other infrastructure. The sudden expense of
war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and
equipment, to undertake profitable projects, for research and development, or to hire employees.
The problem that large organizations run into is that they typically need far more money than
the average bank can provide.

Bonds provide a solution by allowing many individual investors to assume the role of the
lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital
needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy
bonds from other individuals—long after the original issuing organization raised capital.

Types of Bonds

Following are the types of bonds:

1. Fixed Rate Bonds

In Fixed Rate Bonds, the interest remains fixed through out the tenure of the bond.
Owing to a constant interest rate, fixed rate bonds are resistant to changes and
fluctuations in the market.

2. Floating Rate Bonds

Floating rate bonds have a fluctuating interest rate (coupons) as per the current market
reference rate.

3. Zero Interest Rate Bonds

Zero Interest Rate Bonds do not pay any regular interest to the investors. In such types of
bonds, issuers only pay the principal amount to the bond holders.

4. Inflation Linked Bonds

Bonds linked to inflation are called inflation linked bonds. The interest rate of Inflation
linked bonds is generally lower than fixed rate bonds.

5. Perpetual Bonds

Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds
enjoy interest throughout.

6. Subordinated Bonds

Bonds which are given less priority as compared to other bonds of the company in cases
of a close down are called subordinated bonds. In cases of liquidation, subordinated
bonds are given less importance as compared to senior bonds which are paid first.

7. Bearer Bonds

Bearer Bonds do not carry the name of the bond holder and anyone who possesses the
bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by
the bond holder, anyone else with the paper can claim the bond amount.

8. War Bonds

War Bonds are issued by any government to raise funds in cases of war.

9. Serial Bonds

Bonds maturing over a period of time in installments are called serial bonds.

10. Climate Bonds

 Climate Bonds are issued by any government to raise funds when the country concerned
faces any adverse changes in climatic conditions.

Valuation of Bonds:-

Bond valuation is the process of determining the fair price, or value, of a bond. Typically, this
will involve calculating the bond’s cash flow—or the present value of a bond’s future interest
payments—as well as its face value (also known as par value), which refers to the bond’s value
once it matures.

A bond’s interest payments and face value are fixed. This allows an investor to determine what
rate of return a bond needs to provide to be considered a worthwhile investment.

Some other terms that can be helpful in understanding bond valuation include:

 Maturity date: This refers to the length of time until the bond’s principal is scheduled to be
repaid to the bondholder. The maturity date can be short- or long-term. Once the date is
reached, the bond’s issuer—whether corporate or governmental—must repay the bondholder
the full face value of the bond.

 Coupon rate/discount rate: This refers to the interest payments that a bondholder receives.
Typically, it's represented as a fixed percentage of the bond’s face value. Payments may be
made annually or semi-annually, depending on the specifics of the bond.

 Current price: This refers to a bond’s current value, and is typically what’s discussed when
someone mentions “bond valuation.” Depending on several different factors, including market
conditions, the current price of a bond may be at, above, or below par value.
In finance, the value of something today is the present value of its discounted cash flows.

But what about bonds? It turns out, much the same is true.

HOW TO PRICE A BOND

While it may be intimidating if you’re not confident in your financial skills, pricing a bond is
fairly simple. The price of a bond can be determined by following a few steps and plugging
numbers into equations.

1. Determine the Face Value, Annual Coupon, and Maturity Date

Before performing any calculations to value a bond, you need to identify the numbers that you’ll
need to plug in to equations later in the process. Determine the bond’s face value, or par value,
which is the bond’s value upon maturity. You also need to know the bond’s annual coupon rate,
which is the annual income you can expect to receive from the bond. Lastly, determine what
your bond’s maturity date is.

2. Calculate Expected Cash Flow

Next, calculate cash flows using the bond’s face value, annual coupon, and maturity date.

Cash Flow = Annual Coupon Rate x Face Value

3. Discount the Expected Cash Flow to the Present

After calculating cash flow, discount the expected cash flow to the present.

Cash Flow ÷ (1+r)t

In the above formula, “r” represents the interest rate, and “t” represents the number of years for
each of the cash flows.

4. Value the Various Cash Flows

Now, you’re ready to value the individual cash flows and final face value payment in order to
value your bond as a whole.

To value your cash flows, use the following formula for each year:

Cash Flow Value = Cash Flow ÷ (1+r)1 + 30 ÷ (1+r)2... + 30 ÷ (1+r)30

Next, value the final face value payment that you’ll receive at the bond’s maturity using the
following formula:

Final Face Value Payment = Face Value ÷ (1+r)t

Add together the cash flow value and the final face value placement, and you’ve successfully
calculated the value of your bond.

BOND VALUATION: AN EXAMPLE

Let's take an imaginary bond: It has a face value of $1,000, an annual coupon of three percent,
and a maturity date in 30 years. What does that all mean?

It means that the company or country that owes the bond will pay the bondholder three percent
of the face value of $1,000 ($30) every year for 30 years, at which point they will pay the
bondholder the full $1,000 face value.

That leads to cash flows. You would have a series of 30 cash flows—one each year of $30—and
then one cash flow, 30 years from now, of $1,000.

You would then apply a discounting formula:

Cash Flow ÷ (1+r)t

Represented in the formula are the cash flow and number of years for each of them (called "t" in
the above equation). You would then need to calculate the "r," which is the interest rate. Which
should you use? You could use the current interest rate for similar 30-year bonds today, but for
the sake of this example, plug in five percent.

Now you can value the various cash flows. First, you have the coupon payments:

30 ÷ (1+.05)1 + 30 ÷ (1+.05)2... + 30 ÷ (1+.05)30

And then you have the final face value payment, in 30 years:

1000 ÷ (1+.05)30

Together, these total the price at $692.55. This price will ensure that the bondholder receives an
annual return of five percent over the life of the bond.

Now that you have your price, you can play with some of the assumptions to see how things
change. What if the prevailing market interest rate were four percent instead of five percent? In
that case, the bond price would be $827.08. If it were six percent instead of five percent, the
price would be $587.06.

One thing to remember is that the price of a bond is inversely related to the interest rate. When
interest rates go up, the price of a bond goes down, and vice versa.

When the price of the bond is beneath the face value, the bond is "trading at a discount." When
the price of the bond is above the face value, the bond is "trading at a premium."
This can be important if you don't want to actually own the bond for 30 years. If you want to
hold the bond for five years, then you'd receive $30 annually for five years, and then receive that
price of the bond at that time, which will depend on the current interest rates. This is why, while
some long-term bonds (like government Treasury bonds) can be considered "risk-free" over their
full lifetime, they will often vary a great deal in value on a year-to-year basis .