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A bond is a fixed-income investment instrument in which an individual lends money to the government or company at a certain interest rate for a fixed period of time. The borrowing entity repays the principal and interest to the bondholders upon maturity.
A bond is a fixed-income investment instrument in which an individual lends money to the government or company at a certain interest rate for a fixed period of time. The borrowing entity repays the principal and interest to the bondholders upon maturity.
Bonds are widely used by companies, municipalities, state and national governments to finance projects and operations. The holders of a bond are the creditors of the issuer. Details of a bond include the debt's maturity date, which is the date on which the borrowed principal is payable to the bondholder, and often the terms of fixed or floating interest payments to be made by the borrower.
Bonds are debt instruments that represent a loan to the issuer. Bonds enable individual investors to act as lenders. Bonds are commonly used by governments and businesses to borrow money to fund infrastructure such as roads, schools, dams and more. Companies often borrow money to expand their operations, purchase property and equipment, develop profitable projects, conduct research and development, or hire employees.
Bonds are fixed-income securities and one of the major asset classes for individual investors, the other two being stocks and cash equivalents. A borrower issues a bond that contains the terms of the loan, how interest will be paid, and the principal amount of the bond that must be repaid at maturity. Interest payments are part of the return that bondholders receive for lending money to the issuer. The interest rate that determines the amount paid is called the coupon rate.
The initial price of most bonds is usually set at face value (i.e. $1,000 per bond). The actual market price of a bond depends on the issuer's credit quality, length of time to maturity, and how the coupon rate compares to the prevailing interest rate environment. The face value of a bond is the amount paid to the lender when the bond matures.
Note: The market allows lenders to sell bonds to other investors or purchase bonds from other individuals - often long after the original issuing organization has raised capital. Bond investors do not have to hold the bond until maturity.
There are four main categories of bonds on the market. However, you may also see foreign debt issued by global companies and governments on some platforms.
The price of a bond changes daily, with supply and demand determining the observed price. If an investor holds a bond until maturity, he will receive his principal plus interest. However, bondholders can sell their bonds on the open market, and prices can fluctuate. Bond prices and interest rates move inversely. When interest rates rise, bond prices fall so that the bond's interest rate equals the prevailing market rate, and vice versa.
The issuer of a fixed-rate bond promises to pay a coupon based on the face value of the bond. For example, for a bond with a face value of 100 per year. If the market interest rate is also 10% when the bond is issued, investors have no particular preference for investing in corporate bonds or government bonds because the return on both is 50 from the government bond, while still receiving $100 from the corporate bond.
Investors will bid up the price of the bond until it trades at a premium equal to the current interest rate environment, at which point the bond will trade at 100 coupon equivalent to 5%. Likewise, if interest rates spike to 15%, an investor who could receive 1,000 to only earn 666.67.
Yield to maturity (YTM) is the total return expected to be earned if a bond is held to maturity. Yield to maturity is considered the yield on a long-term bond, but expressed as an annual rate.
YTM is the internal rate of return if an investor holds the bond to maturity and all payments are made on time. YTM is used to evaluate the attractiveness of a bond relative to other bonds in the market with different coupons and maturities. The formula for calculating YTM involves finding the interest rate.
Investors can use a bond's duration to measure the expected impact of changes in interest rates on bond prices. Duration represents the change in bond price when interest rates change by 1%. This actual definition is called the modified duration of a bond. Bonds with longer maturities, or bonds with lower coupons, are most sensitive to changes in interest rates.
There are many types of bonds available to investors, depending on the type of interest rate or coupon payment, whether they are callable by the issuer, or other attributes they possess.
Two characteristics of a bondcredit quality and time to maturityare the primary factors that determine a bond's coupon rate. If the issuer has a lower credit rating, the risk of default is higher and therefore the interest paid on these bonds is higher. Bonds with longer maturities also typically pay higher interest. This higher compensation occurs because bondholders face greater interest rate and inflation risk over longer periods of time.
Credit ratings of companies and their bonds are generated by credit rating agencies such as S&P, Moody’s and Fitch Ratings. The highest quality bonds are called "investment grade" and include debt issued by the U.S. government and some very stable companies, such as many utility companies. Debt that is not considered investment grade but has not defaulted is known as "high-yield" or "junk" bonds. These bonds have a higher risk of defaulting in the future, and investors demand higher coupon payments to compensate for this risk.
As interest rates change, bonds and bond portfolios rise and fall in value. The sensitivity to changes in the interest rate environment is called "duration." Using the term duration in this context can be confusing to new bond investors because it does not refer to the length of time before a bond matures. In contrast, duration describes how much a bond's price rises or falls as interest rates change.
Bonds are instruments issued by companies and governments to finance projects and operations. Because bonds traditionally pay a fixed interest rate to creditors, bonds are considered fixed-income instruments. Investors can purchase corporate bonds through a financial institution or online broker, or government bonds through the U.S. Treasury Department's website.
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