Tuesday, June 7, 2016

Bond Basics

It's about time we talk a little bit about one of the worlds largest investment vehicles that don't get enough credit. DEBT*. Yep that is right. Good 'ol fashioned debt.  Debt is exactly what a bond is.  It is a financial obligation to pay someone a set amount of interest, called the coupon rate, over a set period time with full repayment of principal on the maturity date.  Over the years plenty of different bond products have emerged. We'll discuss a few, but for brevity and simplicity we'll stick to the most common types.

Actually my use of the word bonds is a bit mis-leading.  You might here people sometimes refer to bills, or notes.  That's still a loan but here is the general classification.

Bills - debt maturing in less than 1 year.
Notes - debt maturing in 1-10 years.
Bonds - debt maturing in 10 years or more.

Additionally there are secured, and unsecured bonds sometimes called debentures. Secured bonds generally have some physical assets that are used as collateral. Generally secured bonds are issued at a lower interest rate since assets can be sold to recoup capital.  Unsecured bonds(debentures) are the opposite. They have no collateral, and are generally issued based upon the borrowers credibility. Unsecured bonds generally have a higher interest rate, or coupon rate.

Bonds(debt) are issued by corporations, and government at all levels.  So let's take a look at two examples.

Corporation A has decided to issue $1 million worth of bonds in $1,000 denominations. The bond is secured by a factory allowing the company to receive a 5% rate instead of 7%. The $1,000 is known as the par, or face value. The coupon rate is 5% and set to mature on 10 years from now which is when full principal will be repaid. The interest is paid semi-annually.

You decide to buy 1 bond. You will receive two $25 coupon payments each year. At the end of 10 years you will have received $500 in interest.  At the end of 10 years you will be repaid the full $1,000. In total you gave $1,000 today and over ten years you will end up with $1,500.

Government B has decided to issue $1 million worth of notes with a $1,000 face value. The note is not secured by anything other than the faith the money will be repaid.  The coupon rate is 2.5%. The bond will mature in 5 years, and interest is paid annually.

You decide to buy 1 note for investment. You will receive one $25 coupon payment each year. At the end of 5 years you will have received $125 in interest. At the end of 5 years you will be repaid the full $1,000. In total you gave $1,000 today and over 5 years you will end up with $1,125.

Hope that helps with some of the basics.  There are a lot of other metrics and terminology that goes into this area.  We will explore them in more detail as time goes on.


*Ok I'll admit I thought that little pun was hilarious. No, stand up comedy is not my day job but thanks for asking.

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