A bond is a security that is issued in connection with a borrowing arrangement. The borrower issues (i.e., sells) a bond to the lender for some amount of cash; the bond is in essence the “IOU” of the borrower. The arrangement obligates the issuer to make specified payments to the bondholder on specified dates. A typical coupon bond obligates the issuer to make semiannual payments of interest, called coupon payments, to the bondholder for the life of the bond.
Face Value: face value, par value, the payment to the bondholder at the maturity of the bond.
Coupon Rate: The Coupon rate is a bond’s annual interest payment per dollar of par value.
To illustrate, a bond with a par value of $1,000 and a coupon rate of 8% might be sold to a buyer for $1,000. The issuer then pays the bondholder 8% of $1,000, or $80 per year, for the stated life of the bond, say, 30 years. The $80 payment typically comes in two semiannual installments of $40 each. At the end of the 30-year life of the bond, the issuer also pays the $1,000 par value to the bondholder.
Zero-coupon Bond: A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity.
Callable Bonds: A bond that may be repurchased by the issuer at a specified call price during the call period.
Convertible Bonds: A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm.
Put Bond: A bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years.
Floating-rate Bonds: A bond with coupon rates periodically reset according to a specified market rate.
Inflation Adjusted – Treasury Bond: A bond whose coupon rate changes with inflation.
Deferred Coupon Bonds: Carry Coupons, but initial coupon payment is deferred for some period.
Investment Grade Bond: A bond rated BBB and above by Standard & Poor’s, or Baa and above by Moody’s.
Junk Bond: A bond rated BB or lower by Standard & Poor’s, or Ba or lower by Moody’s, or an unrated bond.
The nominal risk-free interest rate equals the sum of (1) a real risk-free rate of return and (2) a premium above the real rate to compensate for expected inflation. In addition, because most bonds are not riskless, the discount rate will embody an additional premium that reflects bond-specific characteristics such as default risk, liquidity risk, maturity risk, tax attributes, call risk, and so on
• Premium bonds: price > par value, Yield Time Maturity < coupon rate
• Discount bonds: price < par value, Yield Time Maturity > coupon rate
• Par bonds: price = par value, Yield Time Maturity = coupon rate
Risks of Investing in Bond:
Interest Rate Risk: Uncertainty about bond prices due to changes in market interest rates.
Call Risk: The Risk that a bond will be called (redeemed) prior to maturity under the terms of the call provision, and that funds must then be reinvested at the then-current (lower) yield.
Prepayment Risk: The uncertainty of the amount of bond principal that will be repaid prior to maturity.
Yield Curve Risk: The risk that changes in the shape of the yield curve will reduce bond values.
Credit Risk: Include the risk of default, the risk of a decrease in bond value due to a rating downgrade, and the risk that the credit spread for a particular rating will increase.
Liquidity Risk: The risk that an immediate sale will result in a price below fair value (the prevailing market price).
Exchange rate Risk: the risk that the domestic currency value of bond payments in a foreign currency will decrease due to exchange rate changes.
Inflation risk: the risk that inflation will be higher than expected, eroding the purchasing power of the cash flow from a fixed income security.
Event Risk: The risk of decreases in a security’s value from disasters, corporate restructurings, or regulatory changes that negatively affect the firm.
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