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A bond is a negotiable debt
security under which the issuer borrows a given amount of money, called the
principal amount. In exchange, the borrower agrees to pay fixed amounts of
interests, also called the coupons, during a specific period of time.
Everything is well defined by the bond contract: the coupon rate is the
interest rate that the issuer pays to the bondholder and the coupon dates
are the dates on which the coupons are paid. Besides the issuer will repay
the total amount of the principal when the bond will reach what is called
maturity (or maturity date).
In short, a bond is a
securitized loan.
First, we can mention the most relevant point that makes bond so attractive,
especially in gloomy periods for stock markets. Indeed, the regular payments
of interest and are repaid the principal value at maturity date. Bonds with
maturity of one year or less are referred to as short-term bonds or debt.
Bonds with maturity of one year to ten years are referred to as intermediate
bonds or intermediate notes. The long-term bonds are issued with a maturity
of at least ten years and commonly up to 30 years. A second important aspect
is that all characteristics of bond are well defined in advance and the
market offers different choices for each of them: coupon rate (also called
coupon yield), coupon date, maturity date can vary from one bond to another
but are known when investing into the given bond. It allows the investor to
fit its investment strategy with its risk and return acceptable levels. Let
consider the following example: for a bond with a principal value of 1000$,
a yearly coupon rate of 5% and a maturity of 2 years. As the yearly coupon
rate is 5%, the issuer of those bonds agrees to pay $50 (5% x $1000) in
annual interest per bond. The second year, the bondholder will receive (per
bond) 50$+1000$, the coupon and the repayment of the principal value. I is
exactly what you can expect if you have bought the bond as defined in this
example and if the issuer of the bond is not in default!
However, at each instant, the value of your bond may fluctuate. Imagine that
the market interest rate is raising to 6% in the second year of your
bondholding and new bonds are issued with a coupon rate of 6%. Clearly, new
investors will not pay $1000 for a bond with a performance of 5% when they
can buy new bonds with an updated coupon rate of 6% for each $1000. What
will happen to your specific bond (with a 5% coupon rate)? It will be sold
by many bondholders who are willing to invest on the new bonds at 6%, and
consequently, the face value of your bond will decrease in order to make it
more competitive against current bonds. Inversely, if interest rates are
decreasing, your bond value will increase as there will be more buyers.
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