A fixed-income instrument/security is a debt investment in which an investor – the lender – loans money to an entity, known as the debtor, which borrows the money for a pre-determined period of time at a variable or fixed interest/coupon rate. The rate quoted is a percentage of the par value of the bond – the amount borrowed – and is typically an annualised rate. Bonds issuers are commonly government bodies and corporate institutions. The borrowed amount is known as the principal.
Why Invest in Bonds?
Bonds with good credit quality provide a steady and reliable stream of income to the investor. Bonds are also seen as a form of diversification from equities in a portfolio. Equities are generally more volatile than bonds; when stock markets become overly volatile, investors typically embark on a flight to safety – rotating their assets from equities into bonds.
For corporations, equity interest is subordinate to debt interest; which means an issuer has to pay off debt interest before distributing any earnings to equity holders.
However, timely coupon distributions are not guaranteed. For instance, a corporation facing short-term cash flow problems may not be able to pay interest on time. Accordingly, a corporation with long-term capitalisation problems may be unable to return the principal at the time of maturity – the time at which the principal is meant to be returned. As such, the coupon rate at issuance is generally dependent on a corporation’s perceived ability to repay interest and principal. Debt-holders generally demand a higher rate on their coupons to compensate for the higher risk of coupons and principal not being repaid. For instance, a company facing bankruptcy has to borrow at a much higher interest rate – and issue a bond with a much higher coupon rate – than a company with abundant and stable cash flow.
Bonds can be traded on the secondary market. Their prices are inversely correlated to the prevailing rates on the market for the bond.
Bond Pricing & Technicalities
The value of a bond is the present value of its future (coupon) payments and the principal repayment. To illustrate:
An investor buys a bond with a face value of $10,000 (the principal) with a fixed 10% annual coupon and a maturity date in 3 years. The coupon rate set at 10% is based on the issuer’s, underwriter’s and originator’s evaluation of the risk associated with the payment of coupons and principal.
Year 1 (1 year later):
The same bond has now been trading in the secondary market for a year. At this time, the market perceived the risk associated with the payment of coupons and principal to be only 6% (this could be due, for instance, to the debtor company receiving cash from the sale of one of its unprofitable operating assets). With 2 years left of 10% coupon payments, the bond is now priced at:
The bond price has appreciated by 7.33%. The investor may sell off the bond on the secondary market for a profit.
Intuitively, this is explained by the fact that if the company were to issue a new bond at year 1 with a 6% rate, the old bond from 1 year ago providing a 10% rate should be worth more.
As a result, if a new investor were to buy the old bond from investor A at $10,733.36, the premium he pays, in spite of the 10% coupon, would make his effective yield-to-maturity 6%. This is simply solving for r in the same equation: