Investment Science: The Basics of investing in Bonds

Tuesday, August 31, 2010

If there is one major thing I learnt from the Investment Science course, it's the investments in bonds and how to immunize your portfolio against interest rates, in this article, we will see the definition of a bond and  the types of bonds with a simple example.

A bond is an investment which pays you a fixed amount of money at it's maturity date and a coupon bond will pay you periodic payments (coupon payments) in addition to the fixed amount of money you will receive at the end of it's maturity.

The price of a bond (P) is the money you pay to buy the bond.
The face value of a bond (F) is the money you will receive at it's maturity date.
The coupon payment (C) is the money you will receive periodically till the maturity date of the bond (based on the coupon rate), this means in a coupon bond, you will receive (C + F) at it's maturity time.

Typically coupons are paid two periods in an year or every 6 months.

As obvious from the above discussion, bonds are classified into two types

1. Coupon bond - Which pay periodic coupons till maturity.

2. Zero coupon bond - Here there are no coupon payments involved, you buy a bond at a price P and get money equal to the face value of the bond (F) at maturity, therefore the Price (P) of a bond is the present value of the bond which pays F in future.

Let me answer some FAQ about bonds (More questions and answers will be added when I get additional information on bonds).

1. Who issues bonds and why? Bonds are issued by Governments, corporations, banks and other institutions whereby they can raise quick capital which can be used for several projects.

2. What if the bond issuer defaults? Typically Government bonds (like the one issued by US treasury) are essentially considered risk-free investments (they never default), however you may need to learn about the Bond credit ratings before buying a bond.

3. What factors influence bond market? The simple answer is interest rate, when you say the bond market is down, it means the interest rates are high and vice-versa, we will learn more about this in a future article.

Let's conclude this section with a small example.

Find the periodic coupon payment (occurs every 6 months or two periods in an year) of a $1000 bond at 5% coupon rate.

Here Coupon payments per year C = 1000 * 5% = $50

Number of periods in an year m = 2

Therefore periodic coupon payment (which occurs every 6 months) = C/m = 50/2 = $25.


Larry Gittens said...

I put all my clients into mutual funds that have a blend of both stocks, bonds, and cash to diversify and minimize the risk. Great post!

Vernon Groston said...

That is really interesting. I’m scared to death of stocks right now. I personally prefer real estate to stocks. I recently saw a report on “high speed traders” on youtube and i don’t feel comfortable competing against MIT grads and computer algorithms. But i plan on checking out bonds as a less volatile alternative.

Prasanna Seshadri said...

Good that you are considering investment in bonds, hope it works out for you.

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