Bonds

Definition

Bonds are debt securities that represent a loan made by an investor to a borrower, typically a corporation or government. They are used to raise capital and generally come with a fixed interest rate, making them attractive for investors seeking steady income. The value of bonds is influenced by present and future cash flows, as well as the risk associated with the issuer's ability to repay the debt.

5 Must Know Facts For Your Next Test

1. Bonds are typically issued with a specific maturity date when the principal amount must be repaid to the bondholder.
2. The price of bonds fluctuates in the market based on changes in interest rates, credit ratings, and economic conditions.
3. Government bonds are considered lower risk compared to corporate bonds, leading to lower yields due to their perceived safety.
4. When interest rates rise, existing bonds with lower rates lose value because new bonds offer better returns.
5. Investors use bonds as a way to diversify their portfolios, balancing the risks associated with stocks.

Review Questions

• How does the concept of present value relate to bonds and their cash flows?
  • The concept of present value is crucial for understanding how bonds work, as it reflects the current worth of future cash flows from the bond. When investors evaluate a bond, they discount its future interest payments and the principal repayment back to the present value using an appropriate discount rate. This helps determine whether a bond is a good investment based on its price relative to the present value of its expected cash flows.
• Discuss how changes in interest rates affect bond prices and investor behavior.
  • When interest rates rise, existing bonds with lower coupon rates become less attractive, causing their prices to fall in the market. Conversely, when interest rates decline, existing bonds become more valuable because they offer higher returns compared to newly issued bonds. This dynamic leads investors to adjust their portfolios; for instance, they may sell off lower-yielding bonds when rates increase or seek out new bonds when rates decrease.
• Evaluate the relationship between credit ratings and bond yields, considering how this impacts investor decisions.
  • Credit ratings play a significant role in determining bond yields because they indicate the risk level associated with an issuer. Higher-rated bonds (e.g., AAA) typically offer lower yields due to their perceived safety, while lower-rated bonds (e.g., junk bonds) must provide higher yields to attract investors willing to take on more risk. This relationship impacts investor decisions as those looking for stable income may prefer high-rated bonds, while risk-seeking investors might target lower-rated options for potentially higher returns.

Related terms

coupon rate: The fixed interest rate that a bond issuer pays to bondholders, usually expressed as a percentage of the bond's face value.

yield to maturity: The total return expected on a bond if it is held until maturity, taking into account its current market price, coupon payments, and the time remaining until maturity.

credit rating: An assessment of the creditworthiness of a bond issuer, reflecting the likelihood that they will be able to meet their debt obligations.