How a Bond Works

A bond is a fixed income financial instrument with complex characteristics.

We reviewed the high-level characteristics of bonds in our blog “Types of Asset Classes” and compared its performance to other asset classes in “Asset Classes 30-Year Performance History.” In this blog, we provide a more detailed view of how bonds work. Companies usually issue bonds with a $1000 Face Value (F), which is approximately the price of the bond at issue. The investors will be paid a fixed coupon (C), typically every 6 months, during the term of the bond and the Face Value when the bond matures. The coupon rate (an annualized number) is set based on the prevailing interest rate and credit risk of the issuing company.

Bonds can also be bought after its issue from the secondary market. The price (P), however, depends on the current interest rate. Bond prices move inversely to the interest rate. But the original Face Value and coupon rates do not change after the issue. The bond prices will increase in a falling interest rate environment because the newer bonds will likely be issued with a lower coupon rate, making the already issued bonds with higher coupons more valuable and vice versa.

The YTM (Yield to Maturity) and Duration are important bond metrics. The YTM represents bond’s current rate of return. It is the interest rate at which the current bond price equals the present value of future cash flows from the remaining coupon payments and the Face Value upon maturity. The yield for a bond currently trading at par (equal to Face Value) is the same as the coupon rate. The yield will be higher than the coupon if the bond trades at a discount (less than Face Value) and lower than the coupon if the bond trades at a premium (more than Face Value).

Duration is a measure of the bond’s price sensitivity to changes in interest rate, expressed in years. It is a kind of weighted average where the time to receive each cash flow (coupon or Face Value) is multiplied by the proportion of that cash flow (expressed in present value) to the total cash flow. In effect, Duration measures the time it takes to recover half the present value of all the future cash flows from the bond.

Duration provides a practical measure with which to determine how much a bond’s price will drop if the interest rate goes up and vice versa. For example, for every 1% change in interest rate, bond prices are expected to move 1% x Duration in the opposite direction. Hence, higher the duration, the greater the interest rate risk for the bond. In general, longer term bonds are more sensitive to interest rate changes. However, bonds held till maturity have no interest rate risk.

Our blog “Bond Types” compares the rates, term, rating and tax treatment for bonds issued by the U.S. Government and by corporations.

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