Greetings! In today’s lesson, we’ll cover bond terminology, features specific to bonds, their risks, and how they are valued. Let’s dive in!
A bond is a debt instrument issued by governments and corporations to raise money. Buyers of the bonds (creditors) are loaning money to the issuers. In case of a bankruptcy, creditors have priority over investors in the distribution of the corporation’s assets.
We’re going to explain the basic terminology of bonds using a hypothetical example. Company ABC wants to raise funds and decides to issue bonds. The bond’s issue price is $10, which is how much the buyer of the bonds pays for it. In one year, the bond at maturity will be worth $12, and ABC will repay the buyer the face value, which is the bond’s value at the repayment date. In the meantime, ABC will pay the bondholder a coupon rate of 10%, which in this case will be $1.20. This refers to a pre-specified interest rate on the bond’s face value. Within one year, the bondholder made a total of $1.20 + ($12-$10) = $3.20.
Types of Bonds
Recently, bonds have become increasingly sophisticated and have developed into an entire sector of the capital markets. Today, we will discuss the most common types of bonds used in bond markets.
Zero-coupon bonds. Zero coupon bonds, as the name implies, do not pay coupons. They are issued at a discount to face value and mature at a higher price. The benefit to the buyer is simply the difference between the issue price and the face value.
Convertible bonds. Convertible bonds are bonds in which the holder has the option to convert to equity shares in the corporation. They are exercised should the price of equity rise, thus making it a valuable option.
Callable bonds. Callable bonds are bonds in which the issuer has the option to call back the bond and repay its maturity value early. This can be done if the interest rate decreases and the issuer prefers to issue the bonds back at a lower coupon rate.
Bullet bonds. Bullet bonds, the most common type of corporate bonds, have no embedded options, pay coupons regularly, and their face value is paid entirely at maturity.
When analyzing bonds for valuation, it’s critical to take a look at the risks they carry. Here is a list of the most common risks and their respective explanations:
Interest rate risk. This risk refers to the price of bonds falling as the interest rates rise.
Default risk. This risk refers to a company defaulting on paying the face value at maturity.
Reinvestment risk. This risk refers to an investor having to reinvest the coupon they receive at a lower interest rate. For example, if you bought a bond that has a return of 5%, you have the option to reinvest the coupon amount. If the current rate is lower than the original 5% you invested, a reinvestment risk occurs.
Call risk. As we discussed with callable bonds, this refers to the risk that the bond will be called when interest rates drop.
Inflation risk. This refers to high inflation diluting the value of the bond.
There are several factors to consider when valuing bonds:
Credit. Similar to when an individual wants to buy a car on credit and needs to get a credit check, corporations have credit ratings as well. When their credit is higher, they can issue bonds for cheaper; when the credit ratings have high risk, their bonds will be issued with higher-paying coupons.
Present value of the discounted cash flows of the bonds: This refers to what the bond would be worth today if it was sold, accounting for the future face value and the future coupons that would be paid. For example, if the bond you purchased at $100 is worth $120 at face value, its value today would be determined by evaluating how many coupons are still left to be paid and discounting the $120-plus coupons at the current interest rate. This is known as the time value of money.
Tomorrow, we’ll cover the exciting world of forwards and futures.
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