| How Bonds Work |
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You can think of a simple bond as an IOU, where you as the bondholder are lending the issuer money and they intend to pay you interest and will pay you back in full at a predetermined time. The interest comes in the form of coupon payments, which are made at a prespecified frequency (usually semi-annual). The time at which you receive your principal is called the maturity date of the bond. For example, lets say you bought a bond from me that paid 5% coupons, semiannually, with a maturity date of 2 years. If you paid $1,000 for this bond, the cashflows would look like the following: $25, $25, $25, $1,025. Every 6 months you would receive $25 as the coupon, and on the final maturity date, you would receive the $25 coupon + the face value of the bond of $1,000. Of course, your receipt of these cashflows is dependent on my ability to pay you at each point in time. Thus, the cashflows are characterized as being "risky" and if I failed to pay coupon or principal, it would be considered an event of default. As a result, you as an investor will want to receive a larger coupon if you deem me to be more risky, and vice versa.
In the example above, the market price (the $1,000 which you paid) happens to be equal to the face value of the bond (the amount of money which you get back when the bond matures = $1,000). The face value can also be referred to as the par value or principal, and is usually quoted in percentages. This bond is said to be "at par" because the market price is equal to the face value. In practice however, bonds do not trade at par and the market price can be substantially different from the face value. For this reason, participants in the bond market tend to think about bonds in terms of yield, instead of price.
Yield represents the annual return that an investor can expect to receive by holding the bond to maturity. Price moves inversely to yield, so as bond yields go up, prices go down, and vice versa. When the market price of a bond is equal to its face value (par), the yield of the bond is equal to its coupon. In the example above, both the bond yield and coupon are 5%. The yield discussed above is also referred to as the yield to maturity. By examining yields to maturity, investors can compare bonds with varying characteristics, such as different maturities, coupon rates or credit quality.
Additional information on bond yields can be found at Investopedia.
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