BONDS BONDS BONDS

A bond is a financial instrument that can be thought of as an IOU. They are issued by governments or corporations when they want to raise capital. 

Key points to consider:

• The buyer of the bond is the lender. 
• The seller of the bond is the borrower e.g. Governments or corporations.
• Principal is the amount the bond will be worth at the maturity date.
• Coupon Rate is the interest rate the borrower agrees to pay periodically, usually annually.
• Maturity is the date when the bond issuer must repay the original bond value.
• Yield is the return the investor expects to receive usually annually until maturity
• Market Price is the current price at which the bond is trading. This current price can be higher or lower than the principal.
• In exchange for the investment the borrower agrees to pay you face value at the maturity date plus

The inverse relationship?

First let’s understand the basics – bond prices and yields move in opposite directions due to the fundamental relationship between the two.

Bond prices fluctuate overtime but generally if interest rates increase then bond prices fall, if interest rates decrease then bond prices rise.

Bond Yield is worked out by bond Coupon / bond price

The bigger the yield the better it is for the investor

Let’s say that you purchased a bond for £1000 with a coupon
rate of 5%, then as soon as you received your bond you sell it on the open
market.

The price for the bond now is £500, the coupon rate is still
5%. Therefore the yield is now (50/500)*100 which is 10%

The price for the bond now is £1500, the coupon rate is
still 5%. Therefore the yield is now (50/1500)*100 which is 3.3%

Price	Coupon (5%)	Yield
£1000	£50	5%
£500	£50	10%
£1500	£50	3.3%

Rising interest rates are bad news for bond prices, as the price of existing bonds decreases as a result.

Example:

Imagine you purchased a 10-Year Treasury Bond in June 2016, during a period when bond yields were at an all-time low. You paid $100 for it and received a coupon rate of 1.5%. 

Now let’s say the yields have risen to 3%. A new bond investor buys a freshly issued bond for $100, with a coupon rate of 3%. A few years later, if you decide to sell your bond, it’s unlikely that you’ll get the full $100 you initially paid. Why would someone pay you for a bond with a 1.5% yield when they could buy a new one with a higher coupon rate? 

Other investors might only be interested in purchasing your bond at a lower price, say $90, which would give them the same yield as a newly issued bond. The opposite is also true, bond prices increase when interest rates fall.