Understanding Bonds

In simple financial terms a bond is a debt instrument. A borrower who is the issuer of the bond seeks to raise money from investors. The borrower may be a government, municipality or corporate, and the investors are the lenders. In return for the loan of funds the borrowers promise to repay the debt on a specific date in the future and to pay interest either along the way or at maturity.

Although this sounds simple enough, there are certain things that a bond investor needs to know before putting money into the bond market. There are some important terms to be aware of when purchasing a bond and these include par value, maturity date, and coupon rate.

The par value (or face value) of a bond refers to the amount of money you will receive when the bond reaches its maturity. What confuses many people is that the par value is not the price of the bond but it is the value at maturity.

A bond’s price fluctuates during its life in response to interest rates. A bond which trades at a price above the face value, it is said to be selling at a premium or at a discount when it sells below its face value. The maturity date is the date that the bond will reach its full value and you will receive your initial investment. As interest rates rise, the value of a bond decreases and if interest rates drop the value of the bond then becomes more sought after and the value rises. People are willing to pay the premium to get the higher interest rate.

The interest may be paid at maturity or at intervals during the term of the investment. Terms may be, six monthly, quarterly or other specified terms. The interest is known as the coupon rate and is normally a fixed rate throughout the life of the bond. The term coupon originates from the past when physical bonds were issued that had coupons attached to them. On the coupon date the bond holder would give the coupon to a bank in exchange for the interest payment.

The bond yield is basically the amount or percentage of return that an investor can anticipate receiving from a bond issue within a specified time period. Calculating the yield involves making use of current data regarding the current price of the bond as opposed to the price at the time of purchase. It also includes the current annual coupon associated with the bond and usually assumes that the buyer will hold the instrument for at least a term of one year.

The advantage of a bond is that they can be traded before maturity if cash is required, making them a liquid investment. Depending on the interest rates they will trade at par or at a premium and therefore it is possible to make a profit or loss on the sale. Holding to maturity does not affect the value of your investment as all things being equal you will get the money back that you deposited.

Bonds can be purchased using a broker or brokerage firm or your financial adviser. Most banks also have a money market department where bonds are transacted.

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