Bonds

Few subjects confuse new investors as much as bonds.  Many struggle to understand that prices and yields move in different directions.  They aren't sure whether to buy individual bonds or a bond fund. They aren't sure where, in fact, to go to buy individual bonds or what bond fund to buy.  This series will examine the basics of bonds.

Terminology

Bonds have some basic terms that all investors should master:

• principal - bonds are typically sold in $1,000 units. The principal amount is the amount the investor will receive when the bond matures.  For example, if the investor purchases a $5,000  Microsoft bond that will mature in 5 years, he will receive interest for 5 years and then get back the principal of the bond.
• coupon - the coupon rate is fixed and determines the interest payment the investor will receive. For example, if the Microsoft bond has a coupon interest rate of 4.5%, the investor will receive $225/year ( 5,000* .045).  In actuality, most bonds pay interest twice/year, so that in this example the bond holder would get $112.50 every 6 months.
• yield-to-maturity - this is the yield that equates the discounted cash flows of the bonds to the price.  See below.
• maturity date - the date on which the principal is paid back.
• principal - the amount paid back at maturity.
• duration - a measure that takes into account the timing of the cash flows and is used to determine the volatility of bond prices.

The best way to get a handle on these terms is to go to an actual bond.  A list of Treasury bonds can be found at Bloomberg :

CLICK TO ENLARGE IMAGE Note that in the black bar we have clicked U.S. and that there are other countries listed for which you could get bond yields.  The yields of other countries are interesting to those following current events and, especially, the debt problems in Europe.

The list of U.S. Treasury bonds is special.  It is the list of what are called "on-the-run" bonds.  These are the most recently issued for each maturity and are the most liquid in the market.

To explain the terms listed above, let's concentrate on the 10-year maturity.  It matures on 8/15/2021.  On that date, holders of the bond will receive back their principal.  Notice that the coupon is 2.125%.  This rate stays constant throughout the life of the bond.  Assume we hold $10,000 in principal of the bond. Then we will receive $10,000 * .02125 = $212.50/year (actually $106.25/every 6 months).  The payments will be on 8/15 and on 2/15 each year.  At maturity, the bond holder will receive the final interest payment as well as the principal of $10,000.

Notice the price is listed as 101-31.  Bonds are priced in $100 units.  This price, since it is above $100, is said to be "above par."  When the bond was issued on 8/15/2011, it was issued at a price very close to par.  The reason it is above par is that yields have declined since the bond was issued.  Like stocks, bonds trade in a secondary market.  In a future post, we will examine the relationship between bond prices and yields.  Here we want to concentrate on what it would cost if we bought $10,000 in principal of this bond.

First ,we need to convert the price to decimal form because bonds trade in 32s/  The price is 101.96875. The cost for $10,000 in principal, therefore, would be 10,000*1.0196875 = $10,196.88.  When you buy a bond in the secondary market, you also have to pay accrued interest (i.e., the interest earned on the bond by the current bond holder up to the time of the sale).

Tomorrow we'll delve further into the world of bonds.