Understanding Bonds: Key Features and Market Dynamics

Bond Characteristics

• Coupon: The interest payment made by the bond issuer, usually expressed as an annual percentage of the bond's face value.
• Par (Face Value): The amount the bondholder receives when the bond matures, typically $1,000.
• Term to Maturity: The time remaining until the bond's maturity date when the issuer must repay the bond's par value.
• Denomination: The face value of the bond, usually in increments of $1,000.
• Quotation: Bonds are quoted as a percentage of their face value (e.g., a bond quoted at 95 is selling for 95% of $1,000, or $950).

Bond Prices, Yield to Maturity (YTM), Current Yield, and Rate of Return (HPR)

• Bond Prices: The market price of a bond depends on interest rates. Prices and interest rates have an inverse relationship.
• Yield to Maturity (YTM): The total return anticipated if the bond is held to maturity. It considers both the bond's current market price and its coupon payments.
• Current Yield: A bond's annual coupon payment divided by its current market price. Current Yield = \(\frac{Coupon Payment}{Bond Price}\)
• Rate of Return (Holding Period Return - HPR): The total return received from holding a bond over a period of time, including coupon payments and capital gains/losses.

Interest Rate Risk and Yield Curves

• Interest Rate Risk: The risk that changes in market interest rates will affect bond prices. Longer-term bonds are more sensitive to interest rate changes.
• Yield Curves: A graph showing the relationship between bond yields (interest rates) and their maturity. Types:
  • Normal (upward sloping)
  • Inverted (downward sloping)
  • Flat

Real versus Nominal Interest Rates

• Nominal Interest Rate: The interest rate unadjusted for inflation.
• Real Interest Rate: The nominal rate adjusted for inflation, showing the purchasing power of the interest earned. Real Interest Rate = Nominal Rate - Inflation Rate

Default Risk and Bond Ratings

• Default Risk: The risk that the bond issuer will not make scheduled interest or principal payments.
• Bond Ratings: Credit rating agencies (Moody's, S&P) assign ratings based on default risk. Bonds are classified as:
  • Investment Grade: AAA to BBB (low default risk)
  • Junk Bonds: BB and lower (high default risk)

Basic Features of Debt versus Equity

• Debt:
  • Fixed income (interest) payments.
  • Priority in liquidation.
  • Does not provide ownership rights.
  • Interest payments are tax-deductible for issuers.
• Equity:
  • Ownership in the company (stocks).
  • Dividends may be paid, but not guaranteed.
  • Residual claim on assets after debt holders.
  • Voting rights (common stock).