10.1 Characteristics of Bonds

Bonds are debt instruments that play a crucial role in finance. They come with key characteristics like par value, coupon rate, and maturity date. Understanding these features is essential for grasping how bonds function and their place in investment portfolios.

Different types of bonds, such as government, corporate, and municipal, offer varying levels of risk and return. The inverse relationship between bond prices and yields is fundamental to bond investing. Special features like callable and convertible bonds add complexity to the bond market.

Bond Fundamentals

Key characteristics of bonds

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• Par value (face value or principal) represents the amount the bondholder will receive at maturity, typically $1,000 per bond
• Coupon rate is the annual interest rate paid on the bond's par value, expressed as a percentage, and determines the periodic coupon payments
  • Coupon payment is calculated by multiplying the coupon rate by the par value
• Maturity date marks the end of the bond's life when the bond issuer repays the par value to the bondholder, and can range from a few months to several decades
• Duration measures a bond's price sensitivity to interest rate changes, with longer duration bonds being more sensitive

Types of bonds compared

• Government bonds are issued by national governments or their agencies (U.S. Treasury bills, notes, and bonds), generally considered low-risk investments
• Corporate bonds are issued by companies to raise capital for various purposes, offer higher yields than government bonds but also carry higher risk, with the creditworthiness of the issuer affecting the bond's risk and yield
• Municipal bonds are issued by state and local governments to fund public projects, often with interest income exempt from federal and/or state taxes, resulting in generally lower yields than corporate bonds due to tax advantages

Bond prices vs yields

• Bond prices and yields have an inverse relationship: when bond prices rise, yields fall, and when bond prices fall, yields rise
• Factors affecting bond prices and yields include:
  1. Changes in interest rates cause bond prices to move in the opposite direction (rising rates lead to falling prices and vice versa)
  2. Credit risk of the issuer impacts bond prices and yields (higher risk results in lower prices and higher yields, while lower risk leads to higher prices and lower yields)
  3. Time to maturity influences the sensitivity of bond prices to interest rate changes (longer maturities are more sensitive, shorter maturities are less sensitive)
• Investment decisions based on the inverse relationship between bond prices and yields involve:
  • Buying bonds when interest rates are expected to fall, potentially leading to higher bond prices and capital gains
  • Selling bonds when interest rates are expected to rise, potentially resulting in lower bond prices and capital losses
  • Considering the investor's investment horizon and risk tolerance (longer-term investors may tolerate more interest rate risk, while shorter-term investors may prefer bonds with less interest rate risk)
  • Evaluating the yield to maturity, which represents the total return anticipated on a bond if held until it matures

Special Bond Features

• Callable bonds allow the issuer to redeem the bond before maturity, typically when interest rates fall, potentially affecting the bond's yield and price
• Convertible bonds give bondholders the option to convert their bonds into a predetermined number of shares of the issuer's common stock, combining features of both debt and equity securities