Bonds

Definition

Bonds are fixed-income securities that represent a loan made by an investor to a borrower, typically corporate or governmental. When you buy a bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value when it matures. This relationship underscores the concept of time value of money, as the present value of future cash flows from bonds must be calculated to assess their worth accurately.

5 Must Know Facts For Your Next Test

1. Bonds are typically issued with a set term length, which can range from a few months to several decades.
2. The market price of bonds can fluctuate based on interest rates; when rates rise, existing bonds tend to decrease in value, and vice versa.
3. Government bonds are often considered safer investments than corporate bonds because they are backed by the full faith and credit of the issuing government.
4. Bonds can be rated by credit rating agencies, which assess their credit quality and help investors understand the risk associated with them.
5. Investors often use bonds as a way to diversify their portfolios, balancing higher-risk investments with more stable income sources.

Review Questions

• How do bonds illustrate the principle of time value of money in investment decisions?
  • Bonds illustrate the time value of money by representing future cash flows that an investor will receive over time. The present value of these cash flows must be calculated to determine whether the bond is a worthwhile investment compared to other opportunities. Since money has a time component, understanding how much future payments are worth today helps investors make informed choices about whether to buy or sell bonds.
• What factors influence the market price of bonds, and how does this relate to interest rates?
  • The market price of bonds is primarily influenced by prevailing interest rates, credit ratings, and overall economic conditions. When interest rates rise, new bonds are issued at higher coupon rates, making existing bonds with lower rates less attractive, thus lowering their market prices. Conversely, if interest rates fall, existing bonds become more valuable since they offer higher coupon payments than newly issued bonds. This inverse relationship between bond prices and interest rates is crucial for investors to understand.
• Evaluate how different types of bonds (government vs. corporate) affect an investor's portfolio strategy considering risk and return.
  • Evaluating government versus corporate bonds involves assessing their different risk-return profiles. Government bonds are generally considered safer because they are backed by sovereign entities, making them less risky but often offering lower returns. Corporate bonds carry higher risks since they depend on the issuing company's creditworthiness; however, they typically offer higher yields. An investor must balance their portfolio according to their risk tolerance and return objectives, ensuring diversification by incorporating both types of bonds to mitigate potential losses while aiming for steady income.

Related terms

Coupon Rate: The interest rate that the issuer of the bond agrees to pay bondholders, typically expressed as a percentage of the bond's face value.

Maturity Date: The date on which the bond's principal amount is due to be repaid to the bondholder, marking the end of the bond's life.

Yield to Maturity (YTM): The total return expected on a bond if it is held until it matures, taking into account all interest payments and the difference between the purchase price and the face value.