Bonds are arguably the most highly employed form of debt in capital markets. In the most basic sense, bonds are loans made by investors to corporations, states or other issuers. As such, the issuer of the bond agrees to pay back at face value at a given date in the future-known as maturity-and, often, to make periodic interest, known as coupons, to the bond holder.
A bond is assumed to be a far safer investment than stocks because it yields predictable streams of income and interest; however, this investment does have risks related to the movement of interest rates. This chapter will help you understand how bonds work, the major components in a bond, and how interest rates affect bond prices and yields.
Understanding How Bonds Work
A bond is essentially debt. When an issuer, for instance, a company, state, or municipality, requires capital, it can issue the bonds to investors. Such investors lend money to the issuer for a certain time period and, in consideration for this lending, the issuer agrees to repay interest from time to time and repayment of the principal amount at maturity. Bonds issued by governments, municipalities, and companies are means of financing various undertakings. Such initiative includes infrastructure development projects, corporate project’s expansion, and government spending.
Bond Investment: Glossary of Terms to Learn
1. Face Value (Par Value): This is the sum that bondholder would get when the bond matures. Usually, it is kept at ₹1,000 for most bonds.
2. Coupon Rate: It is known as the coupon rate that the issuer pays to the bondholder in the form of interest. This rate is usually expressed normally in terms of an annual percentage of the face value of the bond. For example, a coupon of 6% on a face-value bond of ₹1,000 will pay an annual coupon interest of ₹60.
3. Maturity Date: This is the maturity date when the issuer of the bond will return the face value to the bondholder. In actual practice, however, bonds are grouped into three: short term, less than one year; medium maturity between 1–10 years; and long maturity of more than 10 years.
4. Yield: The return an investor can expect from a bond. It is a function of coupon rate, the market price of the bond, and the time to maturity. Yield can be calculated in several different ways: as current yield, which is annual coupon payment divided by the current price of the bond; or sometimes better, as yield to maturity (YTM), that accounts for the total return if the bond is held to maturity.
How Bonds Pay Interest?
The issuer pays the holder a fixed amount of interest at regular intervals – usually annually or semi-annually-called a coupon. That means, for example, if you buy a bond with an annual coupon rate of 5% and a face value of ₹1,000, you are going to get ₹50 per year up to maturity. At maturity, the issuer reimburses the principal of ₹1,000.
How Interest Rates Affect Bond Prices?
The major factors affecting the market prices of bonds are interest rates. Interest rates inversely vary with bond prices; in other words, the more the interest rates increase, the lower the price of bonds. On the other hand, a decrease in interest rates causes higher prices for bonds.
The best way to learn how interest rates work with bonds is to understand that bonds are priced based on yield compared to prevailing market interest rates. Here’s how it works:
1. Rising Interest Rates
Higher interest rates throughout the economy make newly issued bonds have higher coupon rates, therefore more attractive to investors. Therefore, the previously earned bonds with lower coupons do not appear attractive and their prices drop such that their yields equal the prevailing new rates in the market. Thus, in case you have a bond with a 4% coupon, and with an increased interest rate to 5%, your bond is no longer attractive. If you try to sell it, you would have to provide a cut price such that the yield on your bond is at par with the 5% offered by new bonds.
2. Declining Interest Rates
The reverse is true when the interest rate falls. Lowers value from newly issued bonds whereby the coupon rate becomes lower and the previous ones with the higher coupon rates look more attractive. That drives outstanding bonds up because investors are paying higher levels for those bonds so they “lock in” the new high rate. So if you have a 6% coupon and the market interest rates fall to 4%, then your bond is now more valuable because it has a better return than newly issued bonds. This would make it more costly for you to sell your bond before maturity.
Term and Interest Rate Sensitivity
A measure of the price of a bond that describes its interest-rate sensitivity is its duration. In this chapter, we discuss measures of duration, but you must know how to calculate one. Duration is a weighted average of the number of periods until all the cash flows of a bond are received, that is, all the interest payments as well as all the principal payments. The longer maturity, the more interest rate sensitive a bond is. Thus, for example, the price of a 30-year bond with a 5 percent coupon is likely to move much more than the price of a short maturity 5 percent coupon bond to changes in interest rates.
Example of Impact of Interest Rates on Bonds
Assumptions about bonds:
Face Value: ₹1,000
Coupon Rate: 6%
Maturity: 10 years
Consider that the interest rate environment has shifted from 6% to 4%. In this example, the price of your bond will go up for the pure reason that the 6% coupon bond has a higher rate than this newfound market rate at 4%. Once more, were you to sell the bond in the market, the price will rise for the same basic reason: there will be many more buyers attracted to a higher yield that the bond would provide over new bonds sold at 4%.
This essentially boils down to merging extremes, where your bond, due to a drastic increase in the interest rate to 8%, will be sold at a discount. The reason is that its coupon rate is lesser than the new market rate of 8%.
Why Bonds Matter to Investors?
It gives predictable income which is very attractive when times are economically unstable. Most conservative investors rely on bonds for capital preservation and predictable cash flows. Such an investment can achieve market equilibrium in equities. It forms the core of most portfolios and would therefore help an investor to make rational decisions to buy, hold, or sell bonds based on the interest rate dynamics with bond prices.
Conclusion
Bonds are the heart of the world financial system and represent an extremely vital source of financing for governments and corporations alike. Questions of price and yield are inextricably linked with interest rates, so bond investors should be aware of how the economy is evolving.
In the environment of a rising rate of interest , it is the price of bonds that declines, whereas in a declining rate environment, the price of bonds improves. This knowledge of the inverse relationship helps the investor or intermediary navigate the bond markets effectively and make good judgments in strategic investment.
For example, while a seasoned bond investor knows how to save for months or even a long time, such a person knows how bonds work and the effects of interest rates on them, so this knowledge is very important in optimizing your investment strategy.