Bonds: How Lending Investments Work

A bond is a debt security. An investor lends money to an issuer, which may be a government, municipality, or corporation. The issuer generally promises to repay the principal at maturity and may pay interest according to the bond’s terms.

The main ideas to track are:

- The issuer: the borrower. - The investor: the lender. - The principal or face value: the amount associated with repayment at maturity. - The maturity date: when the bond’s term ends. - The coupon rate: the bond’s stated interest rate. - The yield to maturity: a return measure for a bond bought at its market price and held to maturity.

A fixed-rate bond’s stated payments do not automatically change when market interest rates change. As a result, existing fixed-rate bonds generally become less attractive when newer bonds offer higher market rates, so their prices generally fall. When market interest rates fall, existing fixed-rate bond prices generally rise.

Yield to maturity should not be treated as a guaranteed realized return. It is a measure defined for a bond bought at its market price and held to maturity. Its interpretation therefore relies on those stated assumptions, including holding the bond to maturity. A sale before maturity can produce a different result because the bond’s market price may have changed.

The basic sequence is:

1. An issuer raises money by borrowing through a bond. 2. An investor buys the bond and becomes a lender under the bond’s terms. 3. The issuer may make interest payments as specified. 4. At maturity, the issuer generally promises to repay principal, subject to the bond’s terms and the issuer’s ability to meet its obligations. 5. If the investor sells before maturity, the amount received depends on the bond’s current market price and may be above or below face value.

For corporate bonds, the investor receives a debt claim rather than ownership equity merely from holding the bond.

1. Explain what a bond represents from the perspectives of the issuer and the investor.

2. Distinguish face value, coupon rate, coupon payment, maturity, and yield.

3. Why do prices of existing fixed-rate bonds generally move opposite to market interest rates?

4. A $1,000 bond pays a 5% annual coupon. Calculate the annual coupon payment, ignoring any special payment schedule.

5. Compare credit risk, interest-rate risk, inflation risk, and reinvestment risk.

6. Correct this statement: “Holding a bond always guarantees a profit because the coupon rate is fixed.”