Bond

Bond

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.

History

The concept of bonds dates back to ancient times, with the earliest known bond issued by the city-state of Venice in 1157. Bonds have evolved significantly since then, becoming a cornerstone of modern financial markets.

Types of Bonds

Bonds come in various forms, each with unique characteristics. Some of the most common types include:

• Government Bonds: Issued by national governments, these are considered low-risk investments.
• Corporate Bonds: Issued by companies to raise capital, these bonds typically offer higher yields than government bonds.
• Municipal Bonds: Issued by states, cities, or other local government entities, often tax-exempt.
• Zero-Coupon Bonds: Sold at a discount and pay no interest but are redeemed at face value at maturity.
• Convertible Bonds: Can be converted into a predetermined number of shares of the issuing company.

Bond Features

Bonds have several key features that define their structure and value:

• Face Value: The amount paid to the holder at maturity, also known as "par value."
• Coupon Rate: The interest rate the bond issuer will pay on the face value of the bond, expressed as a percentage.
• Maturity Date: The date on which the bond will mature, and the bond issuer will pay the bondholder the face value of the bond.
• Issuer: The entity that issues the bond.

Bond Valuation

The value of a bond is determined by the present value of its expected future cash flows, which consist of periodic coupon payments and the repayment of the face value at maturity. The discount rate used in the valuation is typically the bond's yield to maturity (YTM).

Risks Associated with Bonds

Investing in bonds involves several risks, including:

• Interest Rate Risk: The risk that changes in interest rates will affect the bond's value.
• Credit Risk: The risk that the bond issuer will default on its payments.
• Inflation Risk: The risk that inflation will erode the purchasing power of the bond's future cash flows.

Bond Markets

Bonds are traded in the bond market, which is divided into two main segments:

• Primary Market: Where new bond issues are sold to investors.
• Secondary Market: Where existing bonds are traded among investors.

Conclusion

Bonds are a fundamental component of the financial system, providing a mechanism for raising capital and offering investors a relatively stable income stream. Understanding the various types of bonds, their features, and the risks involved is crucial for both issuers and investors.

See Also

• Stock
• Fixed income
• Yield curve

References

• Investopedia
• Federal Reserve