Bonds

Definition

Bonds are debt securities that represent a loan made by an investor to a borrower, typically a corporation or government. They are used to raise capital and involve regular interest payments, known as coupon payments, until maturity, when the principal amount is returned. Bonds play a vital role in financial markets by providing a way for firms to finance projects and for investors to earn returns, impacting both future value and present value calculations.

5 Must Know Facts For Your Next Test

1. Bonds can be issued by governments (Treasury bonds) or corporations (corporate bonds), each with different risk profiles and interest rates.
2. The price of bonds inversely relates to interest rates; as interest rates rise, existing bond prices typically fall, and vice versa.
3. Investors use bonds to diversify their portfolios and reduce overall risk, as they tend to be less volatile than stocks.
4. Bondholders have a higher claim on assets than shareholders if a company goes bankrupt, making bonds generally less risky than stocks.
5. The time value of money concept is critical in bond valuation, as future cash flows from coupon payments and principal must be discounted to present value.

Review Questions

• How do bonds function within financial markets and why are they essential for firms seeking capital?
  • Bonds function as a means for firms to raise capital by borrowing from investors who purchase these debt securities. In return for their investment, bondholders receive regular interest payments until maturity. This mechanism allows companies to fund projects without diluting ownership through equity financing. The flow of capital from investors into bonds also contributes significantly to liquidity in financial markets.
• Discuss how the relationship between interest rates and bond prices affects investor decisions in financial markets.
  • The relationship between interest rates and bond prices is inverse; when interest rates increase, existing bond prices decrease because new bonds are issued at higher rates. This phenomenon influences investor decisions significantly as they weigh potential returns against risks. Investors may choose to sell existing bonds at lower prices or hold them for steady income through coupon payments, considering market conditions and their investment strategy.
• Evaluate the impact of credit ratings on bond investment decisions and how they relate to portfolio optimization.
  • Credit ratings play a crucial role in shaping bond investment decisions as they assess the risk of default associated with different issuers. Investors often seek bonds with higher ratings for safety, which can lead to lower yields compared to riskier bonds. In terms of portfolio optimization, incorporating bonds with varying credit ratings allows investors to balance risk and return effectively. The efficient frontier can be influenced by selecting a mix of high-rated and lower-rated bonds to achieve desired levels of risk-adjusted returns.

Related terms

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

Yield to Maturity (YTM): Yield to Maturity is the total return anticipated on a bond if it is held until it matures, taking into account all coupon payments and the difference between the purchase price and the face value.

Credit Rating: A credit rating assesses the creditworthiness of a borrower, indicating the likelihood of default on debt obligations, which influences the interest rates on bonds.