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Introduction to Bonds

Prof Aaron Gilbert explains in this article, what are bonds, how are bonds priced and what types of bonds exist.

What are Bonds

  • Bonds are IOU’s that promise repayment of a fixed amount plus interest payments along the way.
  • Bonds, for a variety of reasons, are less risky than stocks. They typically earn more than you would get from a bank saving account, making them a way of increasing returns without taking a lot of risk.
  • This also makes them an excellent investment option for shorter investment horizons.
  • One interesting aspect of bonds is that, unlike stocks which have stayed largely unchanged over recent centuries, bonds have evolved resulting in a range of features which can alter the riskiness, and therefore the return, of the bond.
  • It is also worth noting that while much attention is paid to stocks and stock markets, the bond market internationally has traditionally been larger than the stock market.

Types of Bonds

Vanilla Bond

  • Vanilla Bond is the plainest type of bond. It has the following characteristics Fixed maturity, Fixed coupon rate, and Fixed par value paid at maturity.

Innovations -Maturity

  • Perpetual bonds. It has no fixed maturity period. Some have a call feature so the company can terminate them eventually. Only way to exit as an investor (if not called) is to sell to someone else. But it raises issues around capital gains or losses, and makes them riskier then vanilla bonds.
  • Callable bonds. Company has an ‘embedded option’ to recall the bond early. Company pays a slightly higher par value ($1050 vs $1000 for instance) and usually called if interest rates have fallen. Riskier for investors
  • Puttable bonds. It allows the investors to demand early maturity of the bond. Essentially terminates the bond early if interest rates have increased or company has become riskier. This feature benefits investors reducing risk of bond. However, means a lower yield on the bond

Innovations -Coupon Rate

  • Fixed rate bonds. Pay a predetermined coupon for the life of the bond. As market interest rates change this affects the value of the bond. If interest rates fall, bond increases in value as coupon is relatively higher. If interest rates increase, bond decreases in value as coupon is relatively lower.
  • Floating rate bonds. Coupon rate adjusts on a predefined schedule. It is based on a formula, usually a benchmark interest rate + quoted premium. Such as might be based on LIBOR + 1.5%. As interest rates fall, so to does the coupon, but if rates increase so to do coupons. Great for investors when interest rates expected to increase.

Innovations – Par Value

  • Inflation protected bonds. As inflation increases, the value of the par value increases. Also changes the coupon (coupon rate * par value). Come with lower yield, for example Treasury Inflation Protected Bonds (TIPS).
  • Sinking fund bonds. Issuer maintains a cash fund to repurchase bonds over time. Low risk investment for investors as backed by a cash fund making repayment more certain. Issuer can retire expensive debt early and as low risk is cheaper.
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