2.5 Bond Basics

Bonds are the foundation of the debt securities market and represent a significant portion of the SIE exam. Unlike stocks, which represent ownership, bonds represent a loan from the investor to the issuer. Understanding bond fundamentals - terminology, pricing, and how interest rates affect value - is essential for exam success.

What Is a Bond?

A bond is a debt security representing a loan made by an investor to a borrower. The borrower (issuer) promises to:

1. Pay periodic interest (coupon payments)

2. Repay the principal (face value) at maturity

Think of a bond as an IOU with specific terms about repayment.

Who Issues Bonds?

U.S. Government: Treasury bonds, notes, bills; Purpose - Finance federal operations

Municipalities: State and local government bonds; Purpose - Fund public projects

Corporations: Corporate bonds; Purpose - Finance business operations

Government agencies: GNMA, FNMA; Purpose - Support housing market

Essential Bond Terminology

Par Value (Face Value)

Par value is the amount the issuer will pay at maturity. For most bonds, par value is $1,000.

Important: Par value is also called face value, principal, or redemption value.

Coupon Rate

The coupon rate is the annual interest rate paid on the bond, expressed as a percentage of par value.

Annual Interest = Par Value times Coupon Rate

Example: A bond with 6% coupon rate and $1,000 par pays $60 per year in interest ($1,000 x 0.06 = $60).

Most bonds pay interest semi-annually (twice per year), so a 6% bond pays $30 every six months.

Maturity Date

The maturity date is when the issuer must repay the par value to bondholders. Bond maturities range from short-term (under 1 year) to long-term (30 years or more).

Short-term: Under 1 year; Examples - T-bills, commercial paper

Intermediate: 1-10 years; Examples - T-notes, corporate bonds

Long-term: Over 10 years; Examples - T-bonds, municipal bonds

Bond Pricing

Bonds trade at prices that fluctuate based on interest rates and credit quality. Prices are quoted as a percentage of par value.

Pricing Terminology

At par: Price equals face value; Example ($1,000 par) - $1,000 (quoted as 100)

At a premium: Price above face value; Example - $1,050 (quoted as 105)

At a discount: Price below face value; Example - $950 (quoted as 95)

Reading Bond Quotes

Bond prices are quoted as a percentage of par:

- Quote of 98 = 98% of $1,000 = $980

- Quote of 102.5 = 102.5% of $1,000 = $1,025

Price Calculation: Market Price = Quote times (Par Value divided by 100)

Interest Rate Risk: The Inverse Relationship

The most fundamental concept in bond investing is the inverse relationship between interest rates and bond prices:

- When interest rates rise, bond prices fall

- When interest rates fall, bond prices rise

Why This Happens

Imagine you own a bond paying 4% interest. If new bonds are issued at 5%, your 4% bond becomes less attractive. To sell it, you must lower the price until the yield matches current rates.

Conversely, if rates fall to 3%, your 4% bond becomes more valuable - buyers will pay a premium to get the higher rate.

Duration and Interest Rate Sensitivity

Duration measures how sensitive a bond's price is to interest rate changes. Key factors affecting duration:

Maturity: Higher Sensitivity - Longer maturity; Lower Sensitivity - Shorter maturity

Coupon rate: Higher Sensitivity - Lower coupon; Lower Sensitivity - Higher coupon

Current yield: Higher Sensitivity - Lower yield; Lower Sensitivity - Higher yield

Rule of Thumb: Long-term, low-coupon bonds are most sensitive to interest rate changes. Short-term, high-coupon bonds are least sensitive.

Premium and Discount Bonds

Understanding why bonds trade at premiums or discounts:

Premium Bonds

A bond trades at a premium when its coupon rate is higher than current market rates.

- Coupon rate: 6%

- Current market rate: 4%

- Investor pays more than par for the higher income stream

- Premium will gradually decrease as bond approaches maturity

Discount Bonds

A bond trades at a discount when its coupon rate is lower than current market rates.

- Coupon rate: 4%

- Current market rate: 6%

- Investor pays less than par for the lower income stream

- Discount will gradually decrease as bond approaches maturity

Price at Maturity

Regardless of whether a bond trades at a premium or discount, it will always mature at par value ($1,000). As maturity approaches, bond prices naturally move toward par.

Accrued Interest

When a bond is sold between interest payment dates, the seller is entitled to interest earned up to the sale date. This is called accrued interest.

How Accrued Interest Works

- Buyer pays the market price plus accrued interest

- Seller receives the accrued interest for the period held

- On the next payment date, buyer receives the full coupon

Example: A bond pays semi-annual interest on June 1 and December 1. If sold on August 1, the seller has earned 2 months of the 6-month payment and receives that as accrued interest from the buyer.

Corporate vs. Municipal Calculation

Corporate: 30/360; Assumes 30 days/month, 360 days/year

Municipal: 30/360; Same as corporate

Treasury: Actual/Actual; Uses actual calendar days

Types of Bonds by Payment Structure

Coupon Bonds

Standard bonds that pay periodic interest. Most bonds are coupon bonds.

Zero-Coupon Bonds

Zero-coupon bonds pay no periodic interest. Instead, they are sold at a deep discount and mature at par value.

- Purchase price: $600

- Maturity value: $1,000

- The $400 difference is the investor's return

Tax Note: Even though no cash is received until maturity, investors must pay taxes annually on the "phantom income" (imputed interest). This is called original issue discount (OID).

Callable Bonds

Callable bonds give the issuer the right to redeem bonds before maturity at a specified call price.

- Companies call bonds when interest rates fall

- Investor receives call price (usually par plus a premium)

- Reinvestment risk: Investor must reinvest at lower rates

Key Takeaways

- Bonds are debt securities with fixed interest payments and maturity dates

- Par value is typically $1,000; coupon rate determines annual interest

- Bond prices and interest rates move in opposite directions

- Premium bonds have coupons higher than market rates; discount bonds have lower

- Long-term bonds are more sensitive to interest rate changes

- Accrued interest compensates sellers for interest earned but not yet paid

- Zero-coupon bonds pay no interest but are sold at a discount