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Financial Literacy

Financial Literacy

Home Financial Literacy Investing 101 The Pieces of a Bond

The Pieces of a Bond

Principal - the original amount that you borrow that you eventually have to pay off

When people quote the size of their mortgage, the number they are quoting is usually the principal and it is your pal.

Interest rate = The percentage of the principle that you owe. This number is usually compounded and amortized.

Compounding = The process of computing interest owed. In the case of bank interest for example, you might deposit $1,000 into a bank with a 5% savings account rate. That money is compounded daily as the marketing slogan toots of the bank is .05/365 * principle. So after one day your thousand dollars is worth $1,000.14

Amortization – The process/amount by which your bond decreases over time.

Coupon – A normal vanilla bond pays its interest twice a year. A $500,000 principle 8% coupon bond pays $20,000 twice a year. The total value of the payments each year are called coupons (the opposite of what you bring to the grocery store).

Collateral – Stuff that you offer to the person lending you money so that if you miss a payment and default on your debt obligations. You sacrifice your debt collateral.

Yield - The percentage rate of return on a bond given the price paid for the bond. For example, if investors were nervous about a $500,000 par value bond which had a stated yield of 8% of 40,000 per year in coupons, that bond would trade at a discount. Let’s say instead of $500,000 people were only paying $400,000. Yet the bond is still paying $40,000 in interest. The bond has an effective yield of 10%.

Bond at a discount – A bond that is selling for less than its stated value.

Bond at premium - A bond that is selling for more than it stated value. Investors might be certain the bond will pay off or its credit rating has been upgraded since the bond had been issued. In that case that 8% par value bond could be bought for $600,000. It still pays $40,000, its effective yield is $40000/600000.

Bond at par – Par value is the stated value of the bond when it is issued. For example, a company might seek to raise $10MM. It issues bonds at an 8% compound rate which it is obligated to pay, effectively renting the $10MM for the price of $800,000 per year.

Credit Rating – An estimate of the credit worthiness of a corporation or person. You forget to pay that Mastercard bill? You chinced the gym for a month’s membership? That will show up on your credit rating when you apply for a mortgage.

People carry ratings and so do bonds. They are like the good housekeeping seal of approval. Private publishing agencies such as Moody’s or Standard and Poor’s are hired by bond issuers to audit them, assess the marketplace and provide essentially a grade for that bond paper. Bonds of great certainly carry ratings of double and triple A. Bonds of low certainty carry low grades.

Bond risk - Bond risk is entirely about the ability of an issuer to simply pay his interest costs on time and pay back the principle at the end of the term of the loan that it is due. If investors had great confidence in that ability the bonds will be sold at a low interest (or high price) they are inversely related and vice versa.

The lowest risk bonds are bonds issued and backed by thee US federal government.

Most corporate bonds are priced against the 10 year Treasury bond and that pricing is known as spread to Treasury. The premium paid for the risk comes in the form of basis points. For example, the if the 10 year treasury is yielding 3.5%, a high grade corporate bond of similar duration points might carry a yield of 100 basis points or 4.5%. This would generally be considered A grade paper or better.

Junk is generally define as bonds rated CCC or worse where there is considerable doubt that the issuer can pay back the interest owed or the principle at the end of the duration.

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