Bonds

Definition

Bonds are debt securities that represent a loan made by an investor to a borrower, typically corporate or governmental. When an entity issues a bond, it agrees to pay back the principal amount on a specified maturity date along with periodic interest payments, known as coupon payments, until maturity. This mechanism of borrowing and lending connects to essential financial concepts such as future value, present value, effective interest rates, and the classification of investments like held-to-maturity securities.

5 Must Know Facts For Your Next Test

1. Bonds are typically categorized by their issuer type: government bonds (e.g., U.S. Treasury bonds) and corporate bonds.
2. When valuing bonds, investors use present value calculations to determine their worth based on future cash flows from interest and principal repayments.
3. The effective interest rate accounts for compounding effects and is crucial for understanding the true cost of borrowing for issuers and returns for investors.
4. Bonds classified as held-to-maturity securities are intended to be held until they mature, which means they won't be sold in the short term and are valued at amortized cost.
5. Interest rate fluctuations have an inverse relationship with bond prices; when interest rates rise, bond prices typically fall, and vice versa.

Review Questions

• How do bonds facilitate financing activities for issuers and provide investment opportunities for investors?
  • Bonds serve as a crucial tool for financing activities by allowing issuers like corporations or governments to raise capital without diluting ownership. Investors purchase these bonds, effectively lending money in exchange for regular interest payments and return of principal at maturity. This arrangement benefits issuers by providing immediate funds needed for projects or operations while giving investors a relatively stable income stream through interest payments.
• Discuss how future value and present value calculations apply to evaluating the attractiveness of different bond investments.
  • Future value calculations help investors understand how much their investment in bonds could grow over time based on expected interest payments. Conversely, present value calculations allow investors to determine the current worth of future cash flows from a bond's coupon payments and principal repayment. By analyzing both values, investors can assess whether a particular bond offers a reasonable return compared to its price in the market.
• Evaluate the impact of effective interest rates on bond valuation and investor decisions in the context of changing market conditions.
  • Effective interest rates play a significant role in bond valuation by influencing how investors perceive risk and return. As market interest rates fluctuate, the effective interest rate helps determine a bond's yield compared to its coupon rate, impacting its attractiveness. For instance, if market rates rise above a bond's coupon rate, the bond's price tends to drop, making it less appealing to new investors while also affecting existing holders who may need to sell. This dynamic underlines the importance of understanding effective interest rates in making informed investment choices.

Related terms

Coupon Rate: The coupon rate is the interest rate that the issuer of a bond agrees to pay bondholders, typically expressed as a percentage of the bond's face value.

Maturity Date:

The maturity date is the specified date in the future when the principal amount of the bond is due to be repaid to the bondholder.

Yield to Maturity (YTM): Yield to maturity is the total return expected on a bond if it is held until it matures, taking into account its current market price, coupon payments, and time remaining until maturity.