Bonds

Page 1

What is a bond?

A bond is an IOU from an organisation or government to you as an investor, promising to pay you back the value of that bond at the end of a fixed period. The organisation selling you the bond are using this as a means of raising cash for whatever purpose they have in mind (e.g funding the building of a new factory)

Bonds are a form of marketable loan, ie they can be bought and sold in the secondary bond markets

The issuer of the bond is the debtor and the holder of the bond is the creditor

Bonds usually have a fixed maturity date, which is when the issuer of the bond, i.e the government, will repay the bondholder the money borrowed

Governments issue bonds to finance the budget deficit

Corporate bonds are issued to raise money to finance investments such as a new building

The market price of a bond will rise if confidence in the Government rises

Example

If you purchase a bond worth £1000 with a 10 year maturity, the organisation promises to pay you back that £1000 at the end of the 10 year period. They will also pay you interest annually on the bond at a fixed rate

Page 2

'Interest' or 'Coupon'

Those who issue bonds often use the word 'coupon' instead of the phrase 'interest rate'. The issuer of a bond will promise to give interest at a set rate (e.g 7%) over the entire life span of the bond. In this way, the bond provides an 'income' or 'return' to the purchaser.

The coupon rate is the same as a bond yield, when the bond is first sold on the financial markets

Coupon rate = Total sum of annual coupons / Initial bond price X100

Example

A 10 year bond with £5 coupon with a price of £500.

Calculate the coupon rate = (10 X 5 ) / 500 X100 = 10%

Page 3

Maturity Date

This is the date at which the bond expires. If the bond lasts 10 years, at the end of the 10 years (maturity date), the bond holder receives the value of that bond back.

Page 4

Par

'Par' is the word used to show the value of a bond at intervals over it's lifespan. As a bond can be traded over it's lifetime, the value of that bond is expressed in terms of it's original value.

A bond may be traded before it's expiry date for several reasons. An investor may want their money back sooner than the expiry dates as they need the cash immediately. Others may sell their bonds to finance the purchasing of other bonds.

Example

If £1000 bond if sold after 2 years for £800 it is said to be trading 'below par'. Conversely, if that same bond was sold for £1100 after 2 years it is said to be trading 'above par'

Page 5

Yield

The annual interest payment, or coupon, expressed as a percentage of the market price of the bond.

Assuming the coupon is a fixed annual amount, if the market price of the bond falls, the yield will increase and if the price of the bond rises then the yield will fall.

There is a possible advantage of purchasing a bond after the in initial trading date.

The yield on a bond will fall if the demand for the bond rises

Yield = The Coupon / The Market Price X100

Examples

If the original bond was sold for £1000 at a 5% interest rate, it will receive £50 a year in interest payments. However, if someone purchases the same bond at a later date for a reduced price (say £800) they still receive £50 in interest payments per year as the interest repayments do not change. So £50 as a percentage of £800 is slightly higher than 5% yield per annum (£50 is 6.25% of £800).

A bond is issued with a nominal value of £100 and the annual coupon is £4. The bond has 40 years until it matures. Two years after the bond was issued, the market price of the bond falls to £80.

Calculate the current yield of this bond 4 / 80 X100 = 5% yield

What if the value falls to £70? 4 / 70 X100 = 5.71%

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Risk and 'Default'

Like any investment, purchasing bonds has a risk. The risk comes from the likelihood of the bond issuer defaulting on your original payment. The level of risk of the bond (higher deafult likelihood) is often reflected in the interest/coupon offered on that bond. So, as a Government is the least likely to default on a bond payment (extremely rare), their coupon rate will be low. If you purchase a bond from a smaller, less financially solvent firm, you may find that the interest is much higher which reflects the level of risk.

Example

Whilst yo may purchase a bond for £1000, if the issuer goes bankrupt before the end of your bond lifespan, they will be unable to pay you the £1000 back.

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Tax

The interest paid on bonds is classified as income and is therefore liable to taxation.

Example

So, if you earned £50 in interest payments, this may be liable to a 20% income tax rate (i.e paying the Government £10 in taxation)

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Relationship Between Bonds and General Interest Rates

The relationship between the interim value of a bond and general interest rate are said to be 'inverse'.

If general interest rate is increasing then the value of the bond will decrease and conversely, bond values will increase as interest rates decrease.

The reason for this is that as interest rates increase, there is greater value in placing your money into a savings account. Bond holders may be inclined to move their money from bonds into a savings account. As their bond is seen as less valuable they may have to sell it at a price that is lower than the original cost.

Likewise, as interest rates drop, there is a greater value in placing cash into bonds so people will look to purchase bonds, and therefore increasing their value.