With Compass Asset Management you can buy, sell, and trade a variety of different Bonds and be a part of the world’s most popular markets.
What Is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.
Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.
Bonds Available For Investments
Varieties of Bonds
The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, being recalled by the issuer, or having other attributes.
Zero-coupon bonds – do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. U.S. Treasury bills are a zero-coupon bond.
Convertible bonds – debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. For example, imagine a company that needs to borrow $1 million to fund a new project. They could borrow by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy bonds with an 8% coupon that allowed them to convert the bond into stock if the stock’s price rose above a certain value, they might prefer to issue those.
Callable bonds – also have an embedded option but it is different than what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures. Assume that a company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If interest rates decline (or the company’s credit rating improves) in year 5 when the company could borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.
Characteristics of Bonds
Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium of $1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.
The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
The issue price is the price at which the bond issuer originally sells the bonds.
The market prices bonds based on their particular characteristics. A bond’s price changes on a daily basis, just like that of any other publicly traded security, where supply and demand in any given moment determine that observed price.
But there is a logic to how bonds are valued. Up to this point, we’ve talked about bonds as if every investor holds them to maturity. It’s true that if you do this you’re guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.
The price of a bond changes in response to changes in interest rates in the economy. This is due to the fact that for a fixed-rate bond, the issuer has promised to pay a coupon based on the face value of the bond—so for a $1,000 par, 10% annual coupon bond, the issuer will pay the bondholder $100 each year.
Say that prevailing interest rates are also 10% at the time that this bond is issued, as determined by the rate on a short-term government bond. An investor would be indifferent to investing in the corporate bond or the government bond since both would return $100. However, imagine a little while later, that the economy has taken a turn for the worse and interest rates dropped to 5%. Now, the investor can only receive $50 from the government bond, but would still receive $100 from the corporate bond.
This difference makes the corporate bond much more attractive. So investors in the market will bid up to the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment—in this case, the bond will trade at a price of $2,000 so that the $100 coupon represents 5%. Likewise, if interest rates soared to 15%, then an investor could make $150 from the government bond and would not pay $1,000 to earn just $10