{"id":3573,"date":"2014-10-28T19:15:59","date_gmt":"2014-10-28T13:45:59","guid":{"rendered":"https:\/\/staging-imarticus.kinsta.cloud\/?p=3573"},"modified":"2025-09-01T04:47:26","modified_gmt":"2025-09-01T04:47:26","slug":"what-are-the-basics-of-bond","status":"publish","type":"post","link":"https:\/\/imarticus.org\/blog\/what-are-the-basics-of-bond\/","title":{"rendered":"What are the Basics of Bond?"},"content":{"rendered":"

Bonds are often referred to as the poor, unglamorous cousins of stocks. Stock markets are frequently in the news. They are more sensational as one hears about the wealth generated by investing in stock markets. But it takes a bear market to remind us of the importance of stability and regular income which only bonds can offer.
\nBonds are issued by corporations, governments, municipals for raising capital with a promise to pay interest at regular intervals (except zero coupon) and repay the principal on maturity. The investors in these securities could be individuals, corporations, mutual funds etc. Investors here are seeking an additional return on their surplus funds.
\nBonds are mainly classified as fixed rate, floating rate, zero coupon, callable and puttable bonds
\nFixed rate,<\/strong> as the name suggests, pays a fixed rate of interest throughout the life of the security.
\nFloating rate bonds<\/strong> are indexed to a particular benchmark and pay a return that is equal to the benchmark, in some cases there could be a spread over the benchmark rate. Some of the popular benchmarks are LIBOR, Treasury, Inflation Index etc.
\nZero coupon securities<\/strong> are issued at discount and the final redemption happens at par value. E.g. a one-year bond with an interest rate of 5% will be issued at $952.38 and redeemed at $1,000 after a year. The difference between the par and the discounted value is the interest.
\nCallable bonds <\/strong>can be redeemed by the issuer of the bond before the maturity of the bond. Companies issue callable bonds to protect themselves in case the interest rate drops. This feature is very important for long term bonds – \u00a0if not, issuers can find themselves locked into a high interest rate for a number of years. Companies are willing to pay a premium to redeem the bonds before maturity.
\nPuttable bonds<\/strong> provide the option of redeeming the bonds before maturity to the investor. This helps investors in the event the interest rates increase in the market.
\nUS MarketsBonds vs. Equities<\/strong>
\nBonds are more widely traded than equities. The below graph of US markets clearly indicates that the investment in bonds is much higher compared to equities.
\nSource \u2013 Learning Bonds (https:\/\/www.learnbonds.com\/how-big-is-the-bond-market<\/a>)
\nRisk of Investing in Bonds<\/strong>
\nOne cannot assume that all bonds are risk free. Treasury bonds issued by the US Government are considered the safest as they are backed by \u201cfull faith and credit\u201d of the US Government. Corporate bonds, on the other hand, carry the highest risk. Government and municipal bonds are less risky as compared to corporate bonds.
\nThe bonds risk can be measured in two dimensions:<\/p>\n

    \n
  1. Default risk of the issuer<\/strong> – This can be measured with the help of ratings provided by credit \u00a0rating agencies like Standard and Poor\u2019s, Fitch and Moody\u2019s. Bond ratings are report cards issued for companies. Blue chip and companies with strong fundamentals have high ratings whereas riskier companies have low ratings.<\/li>\n
  2. Interest rate risk – <\/strong>Plays a role if you don\u2019t intend to hold the bond till maturity and want to sell the bond in the secondary market. The problem is interest rates could have increased from the time the bond was bought and the bond is no longer attractive to the buyer.<\/li>\n<\/ol>\n

    Eg: – An investor has bought a 7% $1,000 bond for three years. At the end of year one, the interest rates in the market stand at 8%. Market is paying $80 and bond holder is offering $70. In order to incentivise the buyer, an adjustment has to be made to the value of the bond. The bond will be offered at a price of $980, this adjustment makes the bond equivalent to other bonds in the market.
    \nHow do you measure the sensitivity of the bond to the change in the market interest rates?<\/strong>
    \nDuration<\/strong> measures sensitivity of the bond to changing market interest rates. Simply put, duration is measured in terms of years. Higher the bond\u2019s duration, greater \u00a0is the impact of changing interest rate on the bond. The duration is shorter for interest paying bonds as compared to zero coupon bond.
    \n\u00a0<\/strong>
    \nFactor\u2019s affecting duration of a bond<\/strong><\/p>\n