Anatomy of a Bond

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Characteristics of a Bond

Bonds have a number of characteristics that determine its current value and risk profile.

Face Value or Par Value

The face value is the amount of money that will be returned to the bondholder at the maturity date.

It's important to note that a bonds price is not the par value, though a bond can trade at par. Over the life of a bond, it's price will fluctuate in relation to a number of variables including interest rates, duration, credit risk and others.

Coupons

Coupons are the interest payments that the bondholder will receive periodically. It's also referred to as the interest rate. The term coupon originated when bonds where issued in physical form, with coupons that could be torn off and presented to a bank in exchange for the interest payment.

Coupon payments are typically made on a semi annual basis, however it is common to see monthly quarterly and annually.

Fixed vs Floating

There are 2 main types of coupon payments, fixed and floating payments.

Fixed Coupon Payment- As the name suggests, a fixed coupon payment doesn't change. When the bond is issued, the issuer states the actual coupon payment that will be made periodically over the life of the bond.

Floating Rate Coupons-These bonds have coupon payments that reset periodically and is based off a specified index plus a margin to determine the interest rate. The index could be anything from LIBOR, Federal Funds Rate to S&P 500 or the price of oil.

Investors that believe interest rates will rise in the future, should look at using floating rate notes to capture the high yield rates. Where if an investor believes that lower rates are likely, they should purchase fixed coupon bonds and lock in higher yields.

Maturity

The maturity date is the date that the bond issuer repays the Face Value / Par Value / Principal back to the bondholder. Bond maturities dates can range from a single day right through to 100 years, though 100 year bonds are quite rare.

Some government, such as the UK government have issued bonds that never mature. These bonds are known as perpetual bonds.

Issuer

The issuer, is the entity that sells the bond. Knowing who the issuer is probably the most important piece of information when purchasing a bond. This is because it allows you to determine the default risk, the risk that the issuer won't pay the bondholder back. It's generally considered that US government bonds are risk free, as the US government is extremely unlikely to default on its commitment. However corporations are more likely to default, due to the competitive nature of business. This means that corporate bonds will yield a higher rate of return compared with government debt.

It's important to note that its only the US government debt, that is considered to be risk free, all other countries are considered to have some inherit risk.

Bond Ratings

The bond ratings system aids investors in the ability to determine an Issuers Credit Worthiness. It allows investors to determine the Issuer is investment quality or of junk quality. It's recommended that when you're first starting out trading you stick with investment grade bonds. There are investors that do make large profits trading junk bonds, though it requires a tremendous amount of knowledge about the issuer and the actual bond that has been issued.

Below is a table of the investment ratings that are issued by the big 3 investment rating services, Fitch, Moody's and S&P.

Bond Rating Investment Quality 
Moody\'sS&P/ FitchGradeRisk
AaaAAAInvestmentHighest Quality
AaAAInvestmentHigh Quality
AAInvestmentStrong
BaaBBBInvestmentMedium Grade
Ba, BBB, BJunkSpeculative
Caa/Ca/CCCC/CC/CJunkHighly Speculative
CDJunkIn Default

Optionality

Sometimes you will find bonds that have embedded options, generally they are either callable or putable options.

Callability

Bonds that feature a call option, allow the issuer to terminate the bond before maturity date by repaying the principal. The call feature can only be invoked on specified call dates and not before them. The issuer will generally pay the par value, but in some instance will pay a premium to par value.

Putability

Bonds that feature a put option, give the bondholder the ability to force the bond issuer to repay before the maturity date. The bondholder can only invoke the put option of specified put dates and not when the bondholder chooses.

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