How much would you pay to purchase a bond?
Suppose you are thinking about purchasing a bond. It could be part of a new bond issue – a company selling bonds to raise finance for long-term capital projects. Or you are planning to purchase a bond on the secondary bond market – a bond that has already been issued.
How much would you pay to purchase the bond? If you hold the bond to maturity you will receive a cash payment equal to the face value of the bond. You will also receive annual or semi-annual coupon payments. If the price you pay to purchase the bond is equal to the face value, the return on your investment will be the interest rate written into the bond (which determines the amount of the coupon payments).
But what if this return is not sufficient for you?
Suppose you think inflation in future will be higher than the interest rate on the bonds. Or you think there is a chance the company that issued the bond may fail, and the face value of the bond might not be repaid in full at maturity: you would want a higher return to compensate you for this risk of default. Or suppose the returns available on other types of financial security and in other markets are higher than the interest rate on the bond.
The future cash payments associated with the bond (the coupon payments and the face value) are written into the bond and are fixed. However, the price you pay to purchase the bond is not fixed. If you pay a price that is less than the face value of the bond, you will be paying less to receive the future cash payments, and the return on your investment will be higher than the interest rate on the bond.
Now consider the transaction from the perspective of the seller of the bond. In particular, let us think about a company issuing bonds to raise finance. As we have said, the face value of the bond and the coupon payments are written into the bond. To attract investors, the company might offer the bonds for sale at a price below the face value. As you have just seen, this would increase the return on the bonds for investors. However, if the company reduces the price of the new bonds, the amount of finance they raise from the bond issue will be lower.
To summarise, bonds involve future cash payments to the holder of the bond, in the form of coupons and repayment of the bond’s face value at maturity. The lower the price you pay to purchase the bond (and to receive those future cash payments), the higher will be the return on your investment. And the higher the price you pay to purchase the bond (and to receive the future cash payments), the lower will be the return on your investment.
We capture this relationship between the price you pay to purchase a bond, the future cash payments associated with the bond, and the return on your investment in the bond, in what is called the yield to maturity. You will examine this relationship in the next step.
© SOAS University of London