how bonds work
bonds are debt instruments and represent loans made to the issuer bonds allow individual investors to assume the role of the lender governments and corporations commonly use bonds to borrow money to fund roads schools dams or other infrastructure 12 corporations often borrow to grow their business buy property and equipment undertake profitable projects for research and development or to hire employees 1bonds are fixed income securities and are one of the main asset classes for individual investors along with equities and cash equivalents the borrower issues a bond that includes the terms of the loan interest payments that will be made and the maturity date the bond principal must be paid back the interest payment is part of the return that bondholders earn for loaning their funds to the issuer 3 the interest rate that determines the payment is called the coupon rate 4the initial price of most bonds is typically set at par or 1 000 face value per individual bond the actual market price of a bond depends on the credit quality of the issuer the length of time until expiration and the coupon rate compared to the general interest rate environment the face value of the bond is what is paid to the lender once the bond matures 5markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals long after the original issuing organization raised capital a bond investor does not have to hold a bond through to its maturity date characteristics of bondsbond categoriesthere are four primary categories of bonds sold in the markets however you may also see foreign bonds issued by global corporations and governments on some platforms bond prices and interest ratesa bond s price changes daily where supply and demand determine that observed price if an investor holds a bond to maturity they will get their principal back plus interest however a bondholder can sell their bonds in the open market where the price can fluctuate a bond s price varies inversely with interest rates when interest rates go up bond prices fall to have the effect of equalizing the interest rate on the bond with prevailing rates and vice versa 5the issuer of a fixed rate bond promises to pay a coupon based on the face value of the bond for a 1 000 par 10 annual coupon bond the issuer will pay the bondholder 100 each year 5 if prevailing market interest rates are also 10 at the time that this bond is issued an investor would be indifferent to investing in the corporate bond or the government bond since both would return 100 however if interest rates drop to 5 the investor can only receive 50 from the government bond but would still receive 100 from the corporate bond investors bid up to the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment in this case the bond will trade at 2 000 so that the 100 coupon represents 5 likewise if interest rates soared to 15 then an investor could make 150 from the government bond and would not pay 1 000 to earn just 100 this bond would be sold until it reached a price that equalized the yields in this case to a price of 666 67 yield to maturity ytm the yield to maturity ytm is the total return anticipated on a bond if the bond is held until the end of its lifetime yield to maturity is considered a long term bond yield but is expressed as an annual rate ytm is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled 6 ytm evaluates the attractiveness of one bond relative to other bonds of different coupons and maturity in the market the formula for ytm involves solving for the interest rate investopediainvestors can measure the anticipated changes in bond prices given a change in interest rates with the duration of a bond duration represents the price change in a bond given a 1 change in interest rates 7 this practical definition is the modified duration of a bond bonds with long maturities and also bonds with low coupons have the greatest sensitivity to interest rate changes 