Explaining How Bonds Works as Debt Instruments

A bond is a loan of an investor to a borrower, mostly of a government or a corporation. The borrower commits himself to repaying the face value on a certain maturity date and periodic payment of interest along the way. This article describes the fundamentals of bonds as debt instruments (ตราสาร หนี้ คือ อะไร). Learning about bonds is one way of diversifying an investment portfolio.

Learning about bonds as debt instruments

The basic structure of a bond

All bonds have five essential elements determining the conditions of the loan agreement. The investors are given a fixed amount of interest until the bond matures. The key components of any bond are in the following:

• Face value: This is how much the borrower is committed to pay back on the date of maturity which is normally $1,000 per bond.
• Coupon rate: The fixed interest rate paid to the bond every year that is computed as a percentage of face value.
• Maturity date: This is the exact date on which a borrower will make repayments out of the entire face value of his or her loan to the lender.
• Issue price: The initial price paid by the investors to purchase the bond, which might be higher, lower, or face value.
• Issuer name: The borrower of money could be a government, municipality, corporation or other organization.

How investors earn money from bonds

Investors in the bond market can earn money by receiving the interest rate as well as making a profit by selling the bond to another business. The coupon payment gives reliable and constant income over the time of holding. The following are the mechanics of bonds investing, their returns:

• Interest income: Investors get frequent coupon payments on a regular basis usually semi-annually, until the bond matures.
• Capital appreciation: The purchase of bonds at a discount will give the investor the benefit of increasing in value to a face value at maturity.
• Reinvestment returns: The investors can reinvest coupon payment in new bonds or other assets to multiply the returns.
• Price speculation: Trading bonds before they become due captures price volatile changes with variations in interest rates.

The relationship between bonds and interest rates

The increase or decrease of interest rate will determine the opposite movement of bond prices and this will establish a critical relationship among investors. Increased rates make the same bonds with lower coupons less desirable and their prices decline. The important dynamics of bond pricing are as follows:

• Inverse relationship: When interest rates increase, bond prices decrease and when interest rate decreases, the bond prices increase.
• Duration sensitivity: Bonds with longer maturities have greater price changes with an identical change in interest rates.
• Coupon effect: Bonds with lower coupons are also more sensitive to changes in the interest rates as compared to high coupon bonds.
• Yield to maturity: It is an estimate of the total returns in the case of keeping the bond to maturity and allowing reinvestment of the coupons.

Types of bonds by issuer

Bonds that are issued by different issuers have different levels of risk, potential returns, and tax treatment. Government bonds tend to be safe, and corporate bonds will provide better yields by assuming credit risk. The key categories of bonds include the following:

• Government bonds: Governments of nations issue them, which can be regarded as a very low risk, but with relatively low yields.
• Municipal bonds: These are issued by a state and cities and local agencies and usually involve tax-free interest payments.
• Corporate bonds: Corporate bonds are issued by companies with higher yields to reflect default risk.
• Agency bonds: These are bonds issued by government sponsored corporations which come with implied government support.

Summary

Bonds act as debt instruments that allow investors to lend funds to issuers in the form of certain interest payments and the recovery of the principal after some maturity period. Knowing face value, coupon, maturity date and sensitivity on interest rate will help investors effectively utilise bonds. Bonds can be added to the portfolio to give a source of income, diversification, and decreased aggregate volatility in comparison to stocks.