Fixed Income (Bonds, CDs) Flashcards
What is a bond?
a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time.
The entity repays individuals with interest in addition to the original face value of the bond
Who issues bonds?
used by companies, municipalities, states, and sovereign governments to finance projects and operations
How are bonds linked to interest rates?
The price investors are willing to pay for a bond can be significantly affected by prevailing interest rates. If prevailing interest rates are higher than when the existing bonds were issued, the prices on those existing bonds will generally fall. That’s because new bonds are likely to be issued with higher coupon rates as interest rates increase, making the old or outstanding bonds generally less attractive unless they can be purchased at a lower price. So, higher interest rates mean lower prices for existing bonds.
If interest rates decline, however, prices of existing bonds usually increase, which means an investor can sometimes sell a bond for more than the purchase price, since other investors are willing to pay a premium for a bond with a higher interest payment, also known as a coupon.
Face value or Par Value
The value of the bond at maturity and the reference amount the bond issuer uses when calculating interest payments.
Coupon Rate
The rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. This does not change for the life of the bond.
Coupon Dates
The dates on which the bond issuer will make interest payments.
Maturity Date
The date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
Issue Price
The price at which the bond issuer originally sells the bonds. In many cases, bonds are issued at par/face value.
How do bond prices fluctuate?
A bond’s price changes daily where supply and demand determine that observed price.
If an investor holds a bond to maturity they will get their principal back plus interest.
However, a bondholder can sell their bonds in the open market, where the price can fluctuate. a bond’s price varies inversely with interest rates.
The market value of a bond changes over time as it becomes more or less attractive to potential buyers.
Yield-to-Maturity (YTM)
the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate.
YTM is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.
Advantages of Bonds
- Receive income through the interest payments
- Holding it to maturity gets your principal back
- Profit if you resell at a higher price
Disadvantages of bonds
- They pay back lower returns than stocks
- Companies can default on them
- Bond yields can fall
Yield (Current Yield)
The yield represents the total return an investor can expect from a bond, which includes the interest payments (coupon rate) as well as any gains or loses from price fluctuations.
For the investor who has purchased the bond, the bond yield is a summary of the overall return that accounts for the remaining interest payments and principal they will receive, relative to the price of the bond.
There are different ways to measure yield, but the simplest is the coupon of the bond (in dollars) divided by the current market price.
US Treasury Bonds
- Treasury bills have maturities of 1 year or less. Unlike most other bonds, these securities don’t pay interest. Instead, they’re issued at a “discount”—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
- Treasury notes have maturities between 2 years and 10 years.
- **Treasury bonds **have maturities of more than 10 years—most commonly, 30 years.
Treasury Inflation-Protected Securities (TIPS) have a return that fluctuates with inflation.
Govt Agency Bonds
Some agencies of the U.S. government can issue bonds as well—including housing-related agencies like the Government National Mortgage Association (GNMA or Ginnie Mae). Most agency bonds are taxable at the federal and state level.
These bonds are typically high-quality and very liquid, although yields may not keep pace with inflation. Some agency bonds are fully backed by the U.S. government, making them almost as safe as Treasuries.
