When corporations or governments need long-term funds, they often borrow money from the public by issuing bonds.
A bond represents a loan made by an investor to a borrower, with a promise to repay the principal (face value) at a future date along with periodic interest payments (coupons).
This chapter explains how bonds work, how their prices fluctuate with interest rates, and how investors calculate returns like the Yield to Maturity (YTM).
Understanding bonds is essential for anyone interested in finance, investments, or portfolio management, as they form a crucial part of global capital markets.
Bonds and Bond Valuation
A bond is a long-term debt instrument issued by corporations or governments to raise funds. It is typically an interest-only loan, meaning that the borrower pays interest regularly and repays the principal at the end of the term.
Important Bond Terms
1. Coupon:
Example: A $1,000 bond with a 10% coupon pays $100 in interest per year.
2. Face Value (Par Value):
The amount the borrower agrees to repay at the bond’s maturity date, usually $1,000 per bond.3. Coupon Rate:
The annual coupon divided by the face value of the bond.Example: A bond paying $100 annually on a $1,000 face value has a 10% coupon rate.
4. Maturity:
The specified date when the principal is repaid to investors.5. Yield to Maturity (YTM):
The rate of return an investor earns if the bond is held until maturity, assuming all payments are made as scheduled.As time passes, interest rates in the market change — but a bond’s cash flows (coupon and principal) remain fixed. Therefore, the value of a bond fluctuates inversely with market interest rates.
Relationship Between Interest Rates and Bond Prices
When interest rates rise, bond prices fall.These are called discount bonds because their YTM > coupon rate.
These are called premium bonds because YTM < coupon rate.
This inverse relationship is one of the most fundamental principles in finance.
Interest Rate Risk
Interest rate risk is the risk that a bond’s price will fluctuate due to changes in market interest rates.
This risk depends on two main factors:
1. Time to maturity:
Longer-term bonds have greater interest rate risk.2. Coupon rate:
Lower-coupon bonds are more sensitive to interest rate changes.The sensitivity increases at a decreasing rate — meaning long bonds are riskier but not infinitely so.
Current Yield
The current yield is a simple measure of a bond’s annual return based on its current price:
Current Yield = Annual Coupon Payment ÷ Current Market Price
Example:
A bond with a $100 annual coupon trading at $1,200 has a current yield of 8.33%.
More About Bond Features
Corporations can issue debt securities (bonds) or equity securities (stocks).
While stockholders own a part of the company, bondholders are creditors — they lend money in exchange for future payments.
- Debtor or Borrower: The corporation issuing the bond.
- Creditor or Lender: The investor purchasing the bond.
Unlike equity, debt does not give ownership. Creditors generally have no voting rights. However, they receive priority claims on assets if the firm fails.
Interest paid on debt is considered a tax-deductible expense, reducing the company’s taxable income. Dividends to shareholders, on the other hand, are not tax-deductible.
If debt payments are not made, creditors can legally claim the company’s assets — something that doesn’t occur with equity holders.
The Indenture
An indenture is the formal written agreement between the bond issuer and the bondholders. It specifies the terms of the bond issue, including repayment schedules, interest payments, and protective clauses.
A trustee (often a bank) is appointed to ensure the issuer complies with the indenture’s terms and to manage the sinking fund — an account set aside for early bond redemption.
Terms of a Bond
Face Value:
- Corporate Bonds → Usually $1,000
- Municipal Bonds → Typically $5,000
- Treasury Bonds → Often $10,000
Form:
Bonds may be issued in registered form (recorded ownership) or bearer form (ownership transferred by possession).Security
Bonds may be secured or unsecured, depending on whether specific assets back them.
Secured Bonds:
Backed by collateral, such as property or equipment.
- Collateral Bonds: General assets are pledged.
- Mortgage Bonds: Real estate serves as collateral.
Backed only by the issuer’s reputation.
- Notes: Shorter-term unsecured debts, usually maturing within 10 years.
- Debentures: Longer-term unsecured debts, maturing beyond 10 years.
Seniority
Seniority indicates the order of repayment if the firm defaults.
Senior bondholders are paid before junior or subordinated bondholders.
Call Provision
A call provision allows the issuer to repurchase (redeem) bonds before maturity, typically at a call price higher than par value.
The extra amount paid over par is the call premium.
Call provisions protect the issuer when interest rates fall, allowing refinancing at lower rates.
Protective Covenants
Protective covenants are conditions written into the bond contract to safeguard lenders.
They can be of two types:
1. Negative Covenants:
Restrict the issuer from taking certain risky actions.
Examples:- Cannot issue new long-term debt.
- Cannot merge without lender approval.
- Cannot sell key assets or pay excessive dividends.
2. Positive Covenants:
Require the issuer to perform specific actions.
Examples:- Maintain minimum working capital.
- Provide audited financial statements periodically.
- Keep collateral in good condition.
These ensure transparency and reduce the chance of default.
Types of Long-Term Debt
- Short-Term Debt: Matures within one year.
- Long-Term Debt: Matures beyond one year and may include notes, debentures, or bonds.
Two main categories of long-term debt:
- Publicly Issued Debt – Sold through markets to many investors.
- Privately Placed Debt – Sold directly to financial institutions or large investors.
Bond Valuation
Bond valuation is the process of determining the present value of a bond’s future cash flows — both the periodic coupon payments and the final principal repayment.
Bond Value = Present Value of Coupons + Present Value of Face Value
When market interest rates change, these present values adjust, causing bond prices to move inversely with rates.
Example:
A $1,000 bond paying $80 per year for 10 years (8% coupon rate)
If market interest rate = 10%, the bond will sell below par (discount).
If market rate = 6%, the bond will sell above par (premium).
Bond Markets
Bond markets are where debt securities are traded. Most transactions occur over-the-counter (OTC) rather than on centralized exchanges.
Key terms:
- Bid Price: The price a dealer is willing to pay for a bond.
- Asked Price: The price at which a dealer is willing to sell.
- Bid-Ask Spread: The difference between the two prices, representing the dealer’s profit margin.
Bond markets provide liquidity for investors and flexibility for issuers to raise long-term capital.
Summary
- A bond is a debt instrument that pays interest and repays principal at maturity.
- Bond value moves inversely to interest rates.
- YTM is the total return expected if held to maturity.
- Interest rate risk increases with longer maturities and lower coupon rates.
- Bonds can be secured or unsecured, callable or non-callable.
- Protective covenants safeguard investors by imposing limits and obligations.
- Bid-ask spreads represent dealer margins in bond trading.
Bonds combine fixed income stability with market risk, making them vital tools for both corporate financing and portfolio diversification.
FAQs About Interest Rates and Bond Valuation
1. What is a bond in simple terms?
A bond is a long-term loan made by investors to a company or government in exchange for interest payments and eventual repayment of principal.
2. What is the coupon rate?
It’s the annual interest rate paid on a bond’s face value.
3. What is yield to maturity (YTM)?
The total expected return if the bond is held until it matures.
4. Why do bond prices fall when interest rates rise?
Because investors can buy new bonds with higher rates, reducing demand for existing low-rate bonds.
5. What is interest rate risk?
The risk that bond values will decline due to rising market interest rates.
6. What is a call provision?
A feature allowing issuers to redeem bonds early, often paying a call premium.
7. What are secured and unsecured bonds?
Secured bonds are backed by collateral; unsecured (debentures) are not.
8. What is a bid-ask spread?
The difference between the buying and selling price quoted by bond dealers.
