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Bond Basics

Asset allocation is the foundation of prudent investing and Bonds are the cornerstones of prudent Asset allocation. But do you understand the critical characteristics of bonds?
 
A bond is a loan that an investor makes to a corporation, government, federal agency, or other organization. Consequently, bonds are sometimes referred to as debt securities. Since bond issuers know you aren't going to lend your hard-earned money without compensation, the issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest (Coupon).
 
The bond issuer also agrees to repay you the original sum loaned at the bond's maturity date, though certain conditions, such as a bond being called, may cause repayment to be made earlier. The vast majority of bonds have a set maturity date - a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities because many pay you interest based on a regular, predetermined interest rate-also called a coupon rate - that is set when the bond is issued.
 
There are a number of key variables to look at when investing in bonds:
 
  • Interest Rate
  • Price
  • Zero-Coupon Bonds
  • Maturity
  • Yield
  • Duration
  • Credit Quality
  • Accrued Interest
  • Market Fluctuation

Zero-Coupon Bonds

Bonds that don't make regular interest payments are called zero-coupon bonds-zeros for short. As the name suggests, these are bonds that pay no coupon or interest payment. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures. For example, you might pay €3,500 to purchase a 20-year zero-coupon bond with a face value of €10,000.

 

Bond Interest Rate

Bonds pay interest that can be fixed, floating or payable at maturity. Most debt (Gilt / ixed Interest / Bond) securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Typically, investors receive interest payments semiannually. For example, a €1,000 bond with an 8% interest rate will pay investors €80 a year. When the bond matures, investors receive the full face amount of the bond-€1,000.
 
But some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index. Some bonds have no periodic interest payments. Instead, the investor receives one payment-at maturity-that is equal to the purchase price (principal) plus the total interest earned, compounded annually at the (original) interest rate. Known as zero-coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of €20,000 maturing in 20 years might be purchased for about €5,050. At the end of the 20 years, the investor will receive €20,000. The difference between €20,000 and €5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures.
 

What is a Bond Price?

The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, and maturity. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Yield is the return you actually earn on the bond-based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price.

If you bought at €1,000 and the interest rate is 8% (€80), the current yield is 8% (€80 / €1,000). If you bought at €900 and the interest rate is 8% (€80), the current yield is 8.89% (€80 / €900).
 
Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date. You should ask your investment advisor for the yield to maturity or yield to call on any bond you are considering purchasing. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond's real value to your portfolio.
 

What is a Bond Yield?

Yield is the return you actually earn on the bond-based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price.
 
If you bought at €1,000 and the interest rate is 8% (€80), the current yield is 8% (€80 / €1,000). If you bought at €900 and the interest rate is 8% (€80), the current yield is 8.89% (€80 / €900).
 
Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date. You should ask your investment advisor for the yield to maturity or yield to call on any bond you are considering purchasing. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond's real value to your portfolio.
 

What is Bond Accrued Interest?

Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market, you most likely will catch the bond between coupon payment dates. If you're selling, you're entitled to the price of the bond, plus the accrued interest that the bond has earned up to the sale date. The buyer compensates you for this portion of the coupon interest, which is generally handled by adding the amount to the contract price of the bond.