A bond is a tool used in financial economics to ensure debt security and function as fixed-income financial assets. Like any other asset, the set of payments or income one expects to receive is in present value. This makes the value of payments decrease when market interest rates go up. The value of bonds decrease when inflation is high which reduces the value of the payments.
Credit institutions, companies, corporations, and the government can issue bonds. Bonds vary in by how they mature, their initial set amount, interest rate and return. The principal or nominal amount is the amount of interest the issuer pays. The maturity date is the date when the issuer has to repay the nominal amount and can be set at short term, medium term, or long-term bond maturities. The interest rate that the issuer pays to the holder is the coupon, and is fixed from the start of the bond. The rate of return from the investment of the bond is called the yield and can be measured with market price taken into account.
Bonds provide issuers with a less expensive way to set up long term financing and borrowing. The reason why investors buy bonds is because they can get a return on their investment with relatively low risk. Bond markets have a supply and demand, just like any other market.
There are two main types of bonds – fixed rate bonds (or fixed income bonds) and floating rate bonds. Fixed income bonds are consistently paid over a period of time, known as coupons. Fixed income security is equivalent to a future series of cash flows¹. The value of fixed income bonds is calculated by its yield, which is the calculation of internal rate of return. Risk is the main factor in assessing a bond’s value. Credit risk is the main risk to investors and a higher credit risk means greater yields. Floating rate bonds may regular payments but at a variable rate. A coupon will increase when short term dates rise.
1. Bonds Explained. Retrieved from http://www.barbicanconsulting.co.uk/bonds_explained