Bonds

Definition

Bonds are fixed-income securities that represent a loan made by an investor to a borrower, typically corporate or governmental. When an individual purchases a bond, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value upon maturity. Bonds are a key component of investment strategies, providing a way to earn interest income while diversifying an investment portfolio.

5 Must Know Facts For Your Next Test

1. Bonds are typically issued with a fixed face value, often $1,000, which is returned to the investor at maturity.
2. Bond prices can fluctuate in the market based on changes in interest rates; when rates rise, existing bond prices generally fall and vice versa.
3. Investors consider bonds to be safer than stocks because they provide fixed interest payments and prioritize repayment in case of bankruptcy.
4. Government bonds are often seen as low-risk investments, while corporate bonds carry varying degrees of risk depending on the issuer's creditworthiness.
5. The bond market is one of the largest financial markets in the world, often exceeding the size of equity markets in terms of total issuance.

Review Questions

• How do bonds function as a means of borrowing for issuers and investing for buyers?
  • Bonds function as a borrowing mechanism for issuers, such as corporations or governments, who need capital for various projects or expenses. When investors buy bonds, they are lending their money to these entities with the expectation of receiving periodic interest payments and getting their principal back at maturity. This creates a symbiotic relationship where issuers gain necessary funds while investors earn a return on their investment through interest income.
• Discuss how changes in interest rates can affect the pricing of bonds and why this is important for investors.
  • Changes in interest rates have a significant impact on bond pricing due to the inverse relationship between bond prices and interest rates. When interest rates rise, newly issued bonds offer higher returns, making existing bonds with lower rates less attractive, leading to a decline in their market prices. Conversely, when interest rates fall, existing bonds become more valuable. This relationship is crucial for investors because it affects the market value of their bond holdings and influences their investment strategy.
• Evaluate how understanding bond yield calculations can help investors make informed decisions about their portfolios.
  • Understanding bond yield calculations, particularly yield to maturity (YTM), enables investors to evaluate potential returns from different bonds more effectively. By analyzing YTM alongside other factors like coupon rate and maturity date, investors can compare bonds with varying characteristics and determine which aligns best with their risk tolerance and income needs. This knowledge helps them construct a well-balanced portfolio that meets their investment goals while managing overall risk.

Related terms

Coupon Rate: The coupon rate is the interest rate that a bond issuer pays to bondholders, usually expressed as an annual percentage of the bond's face value.

Maturity Date: The maturity date is the specified date on which the bond's principal amount is due to be paid back to the bondholder, concluding the loan agreement.

Yield to Maturity: Yield to maturity (YTM) is the total expected return on a bond if held until its maturity date, factoring in both interest payments and any capital gain or loss.