Basic Characteristics of Bonds |
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Bonds have three major identifying characteristics. First, they are typically securities issued by a corporation or governmental unit. Second, they usually pay fixed periodic interest installments, called coupons payments. Also available are variable coupon payment bonds, or bonds whose coupon payment changes as market interest rates change. Third, bonds pay a lump sum at maturity that is called the par value, face value, or principle. Bonds are typically classified into two group based on their length of time to maturity. Money market securities are short-term (less than 1 year) obligations and usually require a minimum of $25,000 to purchase. In contrast, capital market securities are long-term securities (more than 1 year) such as Treasury bonds (usually having initial maturities in excess of 10 years). The term capital market securities also apply to stock. Diagram 1 Cash Flow Characteristics of Bonds (a) General Diagram of the Cash Flows Related to Bonds
$Price is the current market price of the bond, $C is the periodic coupon payment, and $Par is the bond’s par value
The current price is assumed to be $955 Diagram 1 shows the cash flow characteristics of a bond in general. Diagram 1(b) shows an example of cash flows from particular bond. The downward pointing arrows in Diagram 1 depict the cash payments from the investor, and the upward pointing arrows depict cash receipts to the investor. Hence, by investing the current market price of the bond today ($Price), there is a promised stream of cash receipts in the future, called coupon payments ($C), and principal payment (or par value, $Par). The bond price today is the present value of its future coupons and par value. Note that if inflation decreases, the discount rate will decrease and the present value of the future cash flows ($C and $Par) will increase, thus increasing the price of the bond. The advantages of bonds to an investor are that they are good sources of current income, and their investment is restively safe from large losses (unless, of course, the bonds have a large risk of default by the issuing company). Another advantage is that bondholders receive their payments before shareholders can be compensated. A major disadvantage of bonds is that the potential profit is limited. Also, bond prices are sensitive to interest rate changes. The larger the change in the interest rate, the larger the potential losses or gains.
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| Last Updated ( Monday, 25 February 2008 ) | ||||||||
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