Bonds are often a perplexing and complex investment vehicle for many individuals. Perhaps, this is due partly to the sheer variety of bonds. The terminology and myriad of technical guidelines or rules inherently present in bond investing can be extremely dry, challenging and even tedious, requiring independent investors to allocate substantial time and energy towards study and research. However, by becoming acquainted with basic terms and concepts as they pertain to bonds, we can better understand and appreciate this particular aspect of the financial market.
1. What is a bond?
A bond is a debt instrument or security. Unlike common stocks, it does not represent ownership. A bond can be loosely defined as an “IOU” certificate. The issuer of the bond is obligated to make specific payments on specified dates to the bondholder. The bondholder is the creditor who has lent money to the bond issuer. When the bond matures at the end of the term, the borrower has to return the principal. Corporate bonds, for example, are usually issued in par value denominations of $1000.
2. What is a bond rating?
A bond rating is assigned after a thorough evaluation of the possibility of the bond issuer’s risk of default. Loosely speaking, it analyzes and evaluates the financial “health” of the bond issuer. Bond rating services as those provided by Standard & Poor’s or Moody’s Investor Service assign ratings to bonds. For investment grade bonds of the best quality, Moody’s assigns the rating of Aaa whereas Standard & Poor’s assigns the rating of AAA.
3. What is the coupon rate?
The coupon rate is the amount of interest that will be paid to the bondholder and it is expressed as a percentage of the par value of the bond. If a bond is $1000 and the coupon rate of interest is 8%, the bondholder will receive $80 a year in terms of the interest payment.
4. What is meant by default risk?
Default risk in this context refers to the creditworthiness of the bond issuer. It is concerned with the possibility of the bond issuer becoming insolvent; of defaulting on its obligations. If the bond issuer (the borrower) becomes insolvent, it will be unable to meet its debt obligations (i.e., the repayment of principal and interest).
5. What does par value mean?
Par value or face value is the final amount not including interest paid by the bond issuer on the bond at the time of its maturity. Special note: par value is distinct from market value; the bond’s market value may be lower or higher.
Additional Pertinent Facts About Bonds:
1. The market price of a bond is not always the same as its par value (i.e., $1000). There is an inverse relationship between the market rate of interest and the market price of a bond. If the market rate of interest increases, the market price of the bond decreases and vice versa.
2. If the market price of a bond is higher than $1000, it means that the price is above par and the bond is bought at a premium. However, if the market price of the bond is below $1000, it implies that the bond is bought below par.
For informational purposes and not intended as a recommendation.