Understanding Bonds - Basic Questions

ironclaw

Hi Everyone,

Expanding my understanding of fiscal markets and I wanted to check some points on Bonds. Note, I'm not currently looking to invest nor am I seeking advice. I'm just clarifying the concept. In very broad terms, this is my example:

A bond of $1000 is issued for 10 years at a fixed 8%.

The Present Value is 1000 / (1.08^10) = $463.19.

The Annuity Present Value is therefore $1000 - $463.19 = $536.81.

So my questions, and apologises for my lack understanding:

• When purchasing this example bond, how much will I pay for it? Am I paying $1000 now for an asset currently worth $463.19?
  
• My understanding now is that if I am buying the bond in Year One, my desire is for market interest rates to stay the same or get lower. Rising interest rates (or inflation) would reduce my Present Value. Correct?
  
• Imagine I come along in the 5th year and see this Bond listed. Under what conditions would I want to buy the bond?
  
• Contrasting to a compound savings account at 8% with an initial investment of $1000, I would have a total of $2158 in my account at the end of 10 years. Why would I buy a bond that issues only $536 in interest? At bond maturity I would have $1000 + $536.

For ever odd

Let’s say a company (I’ll use GE just by way of example) needed to raise $100 million to build a new refrigerator factory and wanted to pay the money back in the year 2020. GE would look to the market to determine what interest rate it would need to offer to get investors to lend them the money. If investors demanded 6%, GE would issue $100 million in bonds with a “coupon rate” (the interest rate) of 6% that would be immediately bought by pre-agreed upon banks, funds, and sometimes, individuals. Most company bonds come in $1,000 denominations (the $1,000 is called “par value”). So for each $1,000 bond that the investor owned, he’d get $60 (6% of $1,000) per year, every year until 2020, at which time he’d get his $1,000 back.

In between the time when GE issues the bond and the time when the bond “matures” (i.e. comes due), investors can sell the bonds on the secondary market. But just like a stock price, the bond price will fluctuate.

Let’s say GE issued that bond three years ago, and since then, the company’s prospects of surviving until 2020, while still good, are decidedly gloomier. If an investor sells his bond today, the buyer will want an interest rate higher than the original 6% to compensate for the extra risk. GE will still pay the new investor $60 per year. So instead, the investor will want to buy the bond for less than par value.

If the new investor buys the bond for $900, while the coupon rate will still be 6%, the yield will be higher — both because he only has to invest $900 to get $60 a year and because he’ll get back $1,000 when the bond matures.

The same thing can happen in reverse, and sometimes investors will buy bonds for above par value, reducing the yield.

http://www.getrichslowly.org/blog/2009/04/21/investing-101-how-bonds-work/


https://www.treasurydirect.gov/indiv/products/prod_tbonds_glance.htm

http://www.investopedia.com/calculator/bondprice.aspx

ironclaw

Thanks For ever odd. I understand the concept of Bonds, but its the particular questions I raised are what I'm trying to wrap my head around. The answer could be staring me in the face but I can't see it

Ardeehey

You are not paying $1000 for something worth $536, you also should receive your $1000 back upon maturity (discounted value taken into account). The interest is your reward for taking the risk of investing your $1000.

Correct about interest rate raises, this explains why corp bond funds have been doing so well in recent times but investors are now seeking other opportunities or are diversifying more as interest hikes loom.

However along with interest rate increases will be price increases, as the value of the bond's yield gets eroded the market price of the bond will decrease...this, in theory, will go towards recovering the yield to an investor.

Savings versus bonds is the choice of the investor...but you have more flexibility with bonds as you can exit without penalty on the markets, likely a savings account you would have a penalty to clear early. Plus let me know if you find an account paying 8% ;-)

Anyway that's just my two cents worth off the top of my head.

Swapp3r

Hi,
I've only looked at this quickly and haven't ran any of the numbers but hopefully I can help you in how to think about bond basics.
1. The short answer is you will only pay what you think it is worth. The market price will be an average judgement of value. By this I mean - in your example a bond pays an 8% coupon. A bond with an 8% coupon may be issued by companies of varying credit quality. A company with a good credit quality would therefore have a higher priced bond compared to a lower quality credit. Essentially you are discounting the bond cashflows by how risky you perceive them to be. If you were an investor in commercial real estate you might do the same - preferring a higher quality tenant (and accepting a lower rental yield) than a less worthy one. If your assessment of risk (the rate at which you discount the future risky cashflows) coincided with the coupon then you might value the bond at par.
2. Yes higher inflation would eat away at the returns of your nominal bond. If the bond coupons were inflation linked they would be broadly the same. The market has a lot of interest rates - government bond rates, swap rates etc, but lower market rates in general would be good for your bond price. In a situation of a say financial crisis or recession you might see market rates - such as government bond yields move lower (prices higher) but if you had invested in the bond of a poorly performing company their yields might still move higher (prices lower) as risk of default increased.
3. Back to #1 really. Have a look at the bond yield and compare it to similar companies, bonds of comparable credit quality, similar maturity and see if you would be happy with that return.
4. I haven't run the numbers here - but you don't consider the reinvestment of the bond coupons so are not comparing like with like.
Hope this helps