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Business Basics 2B: Bonds

Author: oLahav

Business Basics

Part 2- Investment and Bonds

Now that we know how the financial markets work, let's take a look at debt financing and bonds.

What's a bond?

A bond is a contract that says this- if you pay company X a set amount of money today, company X will pay you back that money at a certain date, and will also pay you an additional fixed amount of interest each year until that date.

A few terms to know:

The set amount of money you pay is called face value of the bond.
The date you get paid back is called the maturity date.
The rate of yearly interest is called the coupon rate.

This works exactly like it sounds- you buy a bond, and you get interest at a certain date every year, and after a few years you get your money back. But you can also trade bonds.

How do I trade bonds?

First of all, you should know this important principle- bond prices vary inversely with the interest rates in the economy.

The reason is simple. Say yesterday interest rates were 5 %, and I bought a 5 % bond, for simplicity. Today interest rates are 10 % suddenly. This means new bonds and other vehicles will pay me 10 % interest, not the lousy 5 % interest my bond pays, so I'll want to get rid of my old bond and sell it for cheaper than what I paid for, otherwise nobody would buy it. This shows how when interest rates rise, bond prices fall. The other way around works the same way.

So, let's say I anticipated that interest rates are going to drop tomorrow. This means bond prices will rise. So if I buy a bond today and sell it right away tomorrow, I'll be making a quick profit. That's how we trade bonds.

Bonds have other features too.

Bonds are a safe investment. This is because if a company decides not to pay the interest they owe you, this is considered an act of bankruptcy- they're legally obliged to pay you. Since they're safe, the interest rates are usually low.

If a company does declare bankruptcy, bondholders get paid back before anybody else (stockholders mostly). This means that you're fairly well secured.

Bonds may also be backed up by certain pieces of collateral, such as land or factories (mortgage bonds), financial assets (trust bonds), or nothing (debentures).

And some bonds have special features.

Redemption: The issuer can buy the bond back from the investor by a certain date for a certain price. These bonds usually have a slightly higher coupon to compensate from the possibility of repurchase.
Conversion: Allows the investor to convert the bonds to stock, which is a good thing if stock price rises beyond expectations.
Extendible/retractable: investor can extend or retract the date of maturity.

Last point- yield

What you earn on a bond (without trading) isn't just the interest- if you buy a bond at high or lower than its original worth, you may earn or lose money beyond the interest. The formula for bond yield is:

$\frac{(i * p_o)+\frac{p_o -p_p}{n}}{p_p}$ , where i is the interest rate, po is the original price, pp is the purchase price and n is the number of years left till maturity.