Know your terminology
Understanding Bonds
When a government agency or corporation issues a bond, the investor loans an agreed amount as stated on the bond certificate.
Also stated on the bond certificate is the interest rate and the frequency the bond investor will receive their interest payments.
The terminology used with bonds is consistent amongst the various categories of bonds and they are as follows:
Bond Terminology:
- Issue date: This is the date that the bond was issued on.
- Interest rate: The interest rate on most bonds is a fixed amount and is often referred to as the coupon rate or coupon payment. The term coupon goes back to the days when bond holders held actual coupon booklets that the bond investor would present to receive their interest payment. Nowadays the interest payments are received electronically.
- Maturity date: The date that the bond will terminate and the face value is returned to the bond holder.
- Face Value: This is the amount that will be repaid at the bonds maturity date and is also referred to as Par value or Principle. This is not necessarily the same as the original amount paid for the bond. For example, when treasury bonds are issued they are auctioned and buyers may pay more or they may pay less than the face value.
- Yield to Maturity: This yield calculation becomes relevant after the bond has been issued and its value now is probably different to the issue price. Thus for an investor buying this bond, the yield they will obtain is not the same as the interest rate.
Investors who acquired their bonds when they were issued have the option of selling their bonds on a secondary market known as an over-the-counter (OTC) market. This market consists of bond dealers who buy bonds from investors and in turn sell them to other investors who wish to buy them.
An analogy with stocks is that a bonds issue is like a stock’s initial public offering (IPO) and just like a stock acquired from an IPO that can later be sold on a stock exchange, a bond that was issued can then be sold on the OTC market.
The Price Movement of Bonds
The amount that a bond can be sold for largely depends on the interest rate movements from the time the bond was issued.
For example, if the interest rate of newly issued bonds is greater than that of older bonds, then these new bonds are more appealing to investors.
This has the effect of lowering the value of the older bond if the investor decided to refinance to the newer bond that pays a higher interest rate.
As a general rule, the value of older bonds tends to move in the opposite direction to the movement in interest rates of new bonds issued.
Be careful – the value of bonds move
in the opposite direction to its yield
The value of bonds can also be affected by the confidence bond investors have in the bond issuer.
For example, a company that issued corporate bonds may now be showing an increase in its profits which strengthens its financial position.
This new financial strength may increase the confidence bond investors have that this company will meet all of its interest rate payments, with the effect that bond investors may pay more for this bond for the added security.
The effect on investor confidence can also occur with municipal bonds.
If bond investors are concerned about the government’s ability to meet its interest payments, they will probably pay less for the bonds thus lowering the bonds value.
In general, the price movement of bonds is fairly minimal compared to the price trends exhibited by stocks and are considered a safe haven investment for a portfolio.
While stocks are more volatile than bonds, in the long term stocks considerably outperform bonds.