Principles of Finance

# 10.1Characteristics of Bonds

Principles of Finance10.1 Characteristics of Bonds

## Learning Outcomes

By the end of this section, you will be able to:

• List and define the basic characteristics of bonds.
• List and describe the various types of bonds available.
• Explain how a bond price is inversely related to its return (yield).

## Bonds as Investments

One way to look at bond investments is to consider the fact that any investor who purchases a bond is essentially buying a future cash flow stream that the bond issuer (or borrower) promises to make as per agreement.

Because bonds provide a set amount of cash inflow to their owners, they are often called fixed-income securities. Thus, future cash flows from the bond are clearly stated per agreement and fixed when the bond sale is completed.

Bonds are a basic form of investment that typically include a straightforward financial agreement between issuer and purchaser. Nevertheless, the terminology surrounding bonds is unique and rather extensive. Much of the specialized vocabulary surrounding bonds is designed to convey the concept that a bond is similar to other financial instruments in that it is an investment that can be bought and sold. Much of this unique terminology will be covered later in this chapter, but we can set out some of the basics here with an example.

Let’s say that you buy a $1,000 bond that was issued by Apple Inc. at 5% interest, paid annually, for 20 years. Here, you are the lender, and Apple Inc. is the borrower. ## Basic Terminology We need to know the following basic bond terms and pricing in order to apply the necessary time value of money equation to value this Apple, Inc. bond issue: • Par value: A bond will always clearly state its par value, also called face amount or face value. This is equal to the principal amount that the issuer will repay at the end of the bond term or maturity date. In our example, the par value of the bond is$1,000.
• Coupon rate: This is the interest rate that is used to calculate periodic interest, or coupon payments, on the bond. It is important to note that coupon rates are always expressed in annual terms, even if coupon payments are scheduled for different periods of time. The most common periods for coupon payments other than annual are semiannual and quarterly. Coupon rates will typically remain unchanged for the entire life of the bond. In our example, the coupon rate is the 5% interest rate.
• Coupon payment: This refers to the regular interest payment on the bond. The coupon or periodic interest payment is determined by multiplying the par value of the bond by the coupon rate. It is important to note that no adjustment needs to be made to the coupon rate if the bond pays interest annually. However, if a bond pays interest on a semiannual or quarterly basis, the coupon rate will have to be divided by 2 or 4, respectively, to convert the stated annual rate to the correct periodic rate. In our example, coupons are paid annually, so the periodic or annual interest that is paid is equal to $1,000×0.05=501,000×0.05=50$. You may notice that because these payments are the same amount and made at regular intervals, they constitute an annuity stream (refer to Time Value of Money II: Equal Multiple Payments.
• Maturity date: The maturity date is the expiration date of the bond, or the point in time when the term of a bond comes to an end. On the maturity date, the issuer will make the final interest or coupon payment on the bond and will also pay off its principal, or face value. In our example, the maturity date is at the end of the 20-year period.
• Yield to maturity (YTM): The YTM is essentially the discount rate used to bring the future cash flows of a bond into present value terms. It also equals the return that the investor will receive if the bond is held to maturity. The YTM helps quantify the overall investment value of a bond. We will explore how to compute this rate later in the chapter.

Table 10.1 displays a selected listing of bonds available for purchase or sale. First, let’s review the columns so you can learn how to read this table.

Issuer Bond Type Current
Price %
Callable? Coupon
Rate %
Maturity
Date
Yield% Rating
3M Co. Corp 105.120 Yes 2.25 9/19/2026 1.240 A+
Alteryx Corp 98.818 No 1.00 8/1/2026 1.206 None
Anheuser-Busch Cos. LLC Corp 125.319 Yes 5.95 1/25/2033 3.340 BBB+
City of Chicago Muni 103.164 Yes 5.00 1/1/2033 1.030 BBB+
Coca-Cola Co. Corp 95.206 Yes 1.00 3/15/2028 1.731 A+
DuPont De Nemours Inc. Corp 100.815 Yes 2.17 5/1/2023 1.775 BBB+
Exxon Mobil Corp. Corp 107.325 Yes 3.18 3/15/2024 0.483 AA-
Ford Motor Co. Corp 114.880 No 7.13 11/15/2025 3.623 BB+
Nordstrom Inc. Corp 112.905 No 6.95 3/15/2028 4.758 BB+
Tennessee Energy Acquisition Corp. Muni 102.168 No 5.25 9/1/2021 0.451 BBB+
Table 10.1 Bond Information, March 2021 (source: FINRA-Markets.Morningstar.com)
• Column 1: Issuer. The first column shows the company, city, or state issuing the bond. This bond listing includes two municipal issuers (City of Chicago and Tennessee Energy) as well as several corporate issuers.
• Column 2: Bond Type. This describes the issue of the bond and indicates whether it is a corporation or a municipality.
• Column 3: Current Price. The third column shows the price as a percent of par value. It is the price someone is willing to pay for the bond in today’s market. We quote the price in relation to $100. For example, the Nordstrom bond is selling for 112.905% of its par value, or$112.905 per $100.00 of par value. If this bond has a$1,000.00 par value, it will sell for . Note: Throughout this chapter, we use $1,000 as the par value of a bond because it is the most common par value for corporate bonds. • Column 4: Callable? This column states whether or not the bond has a call feature (if it can be retired or ended before its normal maturity date). • Column 5: Coupon Rate. The fifth column states the coupon rate, or annual interest rate, of each bond. • Column 6: Maturity Date. This column shows the maturity date of the issue—the date on which the corporation will pay the final interest installment and repay the principal. • Column 7: Yield. The seventh column indicates each bond’s yield to maturity—the yield or investment return that you would receive if you purchased the bond today at the price listed in column 3 and held the bond to maturity. We will use the YTM as the discount rate in the bond pricing formula. • Column 8: Rating. The final column gives the bond rating, a grade that indicates credit quality. As we progress through this chapter, we will examine prices, coupon rates, yields, and bond ratings in more detail ## Types of Bonds There are three primary categories of bonds, though the specifics of these different types of bond can vary depending on their issuer, length until maturity, interest rate, and risk. ### Government Bonds The safest category of bonds are short-term US Treasury bills (T-bills). These investments are considered safe because they have the full backing of the US government and the likelihood of default (nonpayment) is remote. However, T-bills also pay the least interest due to their safety and the economics of risk and return, which state that investors must be compensated for the assumption of risk. As risk increases, so should return on investment. Treasury notes are a form of government security that have maturities ranging from one to 10 years, while Treasury bonds are long-term investments that have maturities of 10 to 30 years from their date of issue. Savings bonds are debt securities that investors purchase to pay for certain government programs. Essentially, the purchase of a US savings bond involves the buyer loaning money to the government with a guaranteed promise that they will earn back the face value of the bond plus a certain amount of interest in the future. Savings bonds are backed by the US government, meaning that there is virtually no possibility of the buyer losing their investment. For this reason, the return on savings bonds is relatively low compared to other forms of bonds and investments. Municipal bonds (“munis”) are issued by cities, states, and localities or their agencies. Munis typically will return a little more than Treasury bills while being just a bit riskier. ### Corporate Bonds Corporate bonds are issued by companies. They carry more risk than government bonds because corporations can’t raise taxes to pay for their bond issues. The risk and return of a corporate bond will depend on how creditworthy the company is. The highest-paying and highest-risk corporate bonds are often referred to as non-investment grade or, more commonly, junk bonds. Corporate bonds that do not make regular coupon payments to their owners are referred to as zero-coupon bonds. These bonds are issued at a deep discount from their par values and will repay the full par value at their maturity date. The difference between what the investor spends on them in original purchase price and the par value paid at maturity will represent the investor’s total dollar value return. Convertible bonds are similar to other types of corporate bonds but have a feature that allows for their conversion into a predetermined number of common stock shares. The conversion from the bond to stock can be done at certain times during the bond’s life, usually at the discretion of the bondholder. ## The Global Bond Market versus the Global Stock Market Bonds have long been a trusted investment vehicle for many investors. Though the global fixed-income debt market remains considerably larger than the global stock market, this is not an entirely fair comparison. Bond markets include sovereign bonds, or bonds that are issues by governments, while stock markets do not. Some experts believe that a more relevant comparison is between the value of corporate bond markets only (excluding sovereign bonds) and total stock market value. The chart in Figure 10.2 provides global market value information by category so that we may make our own conclusions about these markets. Figure 10.2 Global Bonds versus Stocks: Total Market Values ($Trillions), November 2020 (data source: Nasdaq)

While the total value of bond markets continues to exceed that of stocks, the prevailing trend over the past several years has been that stock markets are gaining in terms of total market size. The primary reason for this is that stocks have traditionally outperformed bonds in terms of return on investment over extended periods of time and are likely to continue to do so. This makes them more attractive to investors, despite the higher risk associated with stock.

## The Two Sides of a Bond Investment

There are essentially two sides to a bond investment, meaning the bondholder will receive two types of cash inflow from the bond investment over its term. These are the payment of the par value at maturity (often referred to as payment of the face value of the bond at term end), and the periodic coupon payments (also called interest income) from the bond. These coupon payments are contractually determined and clearly indicated in the bond issue documentation received by the bondholder upon purchase.

As a result of these two types of inflow, bond valuation requires two different time value of money techniques—specifically, present value calculations—to be computed separately and then added together.

## The Relationship between Bond Prices and Interest Rates

Bond price and interest rate have an inverse relationship. When interest rates fall, bond prices rise, and vice versa (see Figure 10.3). If interest rates increase, the value of bonds sold at lower interest rates will decline. Similarly, if interest rates decline, the value of fixed-rate bonds will increase. An exception to this general rule is floating-rate bonds (often referred to as “floaters,” floating-rate notes, or FRNs).

Figure 10.3 The Seesaw Effect of Bond Prices and Interest Rates

A floating-rate note is a form of debt instrument that is similar to a standard fixed-rate bond but has a variable interest rate. Rates for floating-rate bonds are typically tied to a benchmark interest rate that exists in the economy. Common benchmark rates include the US Treasury note rate, the Federal Reserve funds rate (federal funds rate), the London Interbank Offered Rate (LIBOR), and the prime rate.

So, investors who decide to purchase normal (fixed rate) bonds may not be thrilled to hear that the economy is signaling inflation and that interest rates are forecasted to rise. These bond investors are aware that when interest rates rise, their bond investments will lose value. This is not the case with floating- or variable-rate bonds.

Bonds with very low coupon rates are referred to as deep discount bonds. Of course, the bond that has the greatest discount is the zero-coupon bond, with a coupon rate of zero. The smaller the coupon rate, the greater the change in price when interest rates move.

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