The bond market is one of the most central components of the US economy. It is an extremely common instrument of debt on both the primary and secondary markets and works to provide funding for public and private expenditures and projects.
Bonds are exciting because they can be used to fund a vast array of interesting projects. The US government issues bonds along side corporations and municipalities, and the types of projects that they can be funding are as diverse as your imagination.
In its simplest form, a bond is a loan that is made between a borrower and a lender. The borrower is referred to as an issuer and the lender is known as a bondholder.
Also known as its “par value”, this is the amount that the lender will receive at the maturity of the bond. A bondholder can profit from the face value of a bond if the bond was originally purchased “below par”. Otherwise, the profit will result from interest rates.
With any type of loan, the borrower pays the lender interest for the privilege of using their money. With a bond, this comes as a series of scheduled payments that are often referred to as “coupons”.
The term “coupon” is a holdover from a time before computers where bonds were issued in paper form. These were called “bearer certificates” and whoever was in possession of this paper held with it proof of ownership.
The coupon was a small clipping that could be presented to claim each scheduled interest payment.
A coupon rate is essentially equivalent to an interest rate in any loan, however the term comes again from the days of coupon clipping.
This rate is found by adding up all of the coupon payments and dividing it by the face value of the bond.
For example, a bond with a face value of $1,000 can be offered on the market as a 5-year bond with an annual coupon of 5%. This means that in five years, the borrower will repay you $1,000 after paying coupons that equate to $200 a year.
The payment of coupons typically occurs semi-annually, so in this case, $100 dollars would be paid to the bondholder every 6 months.
A Dollar Today Is Worth More Than a Dollar Tomorrow
Without getting too far into strategies for the bond market, it is important to know how to calculate the present value (PV) of a bond.
Since a bond is an investment much like any other, the present value will determine whether investing in a bond will be profitable compared to other options.
The price of most bonds is driven by the market. How much it is worth depends on what people are willing to pay for it.
How much should you be willing to pay for a bond?
Imagine a $1000 10-year bond at 3%.
The PV of a bond will tell you, based on how much money you will have at maturity, exactly how much you should be willing to pay for it.
PV = $30/(1+r) + $30/(1+r)² … + $30/(1+r)¹º + $1000/(1+r)¹º
The term r here represents the interest rate that you are comparing this investment against. The point of the PV is to show the value of your investment if you were to have made it in another market.
Naturally, it is good to test this investment against the prevailing interest rate (currently 1.25%). Notice that, in this equation, the higher the interest rate (r), the lower the value of the bond.
This is because when the interest rate of alternative investments rises, the premium earned from choosing this bond over that investment decreases.
A perpetuity is a bond (or other type of investment) that pays out a certain amount each year forever.
The way that you would calculate the present value of a perpetual bond would be:
PV = Face Value/r
Why Should I Invest in Bonds?
There are so many reasons why bonds might be an attractive option for you.
The first is that there are so many types of bonds, that you can find the ones that best suit your investment strategies.
Government Bonds (Treasuries especially) are widely known as some of the safest investments that you can make. This is mainly true because there is very little risk that the US Treasury will default.
The chance that the issuer of a bond will default and be unable to pay the rest of the value of the bond is known as credit risk. The other type of risk associated with bonds is known as interest risk that has to do with vulnerabilities related to changes in interest rates.
For an understanding of the various risks associated with bonds, look for my next article on Bond Risk.