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Understanding Bond Basics and Yields

Bonds are debt instruments where an investor loans money to a borrower (bond issuer) in exchange for regular interest payments and repayment of the principal when the bond matures. There are two main types of bonds: risk-free bonds issued by governments and riskier corporate bonds. Bond prices fluctuate inversely with bond yields - as prices go up, yields go down and vice versa. Investors consider factors like time to maturity, credit quality, and expected changes in interest rates when choosing between different bonds to maximize returns while balancing risk.

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20 views2 pages

Understanding Bond Basics and Yields

Bonds are debt instruments where an investor loans money to a borrower (bond issuer) in exchange for regular interest payments and repayment of the principal when the bond matures. There are two main types of bonds: risk-free bonds issued by governments and riskier corporate bonds. Bond prices fluctuate inversely with bond yields - as prices go up, yields go down and vice versa. Investors consider factors like time to maturity, credit quality, and expected changes in interest rates when choosing between different bonds to maximize returns while balancing risk.

Uploaded by

saanmit
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Chapter 17: Bonds

Equity = Ownership, Stocks


Debt = Borrower/ender, bonds
o Corner stone: 1! year "#S# $reasury, and $%Bi&&
're risk (ree rates and used as C')*
Bond Price Movement
o Discounted cash +ows o( in+ows
Coupon/,nterest
o 's prices -oes up, the yie&d -oes down and .ice .ersa#
o /hy does it ha.e a price 0o.e0ent1
Because i( so0eone buys a bond at a discount, the
.a&ue o( the bond wi&& decrease#
'nd the yie&ds wi&& -o up
o *onday:
2ohn buys a 1! year "S $reasury at a yie&d o( 34# ,t
pays 51!! at par .a&ue#
o $uesday:
6ie&d -oes up to 74# 2ohn -ets upset#
8ow do you bui&d yie&ds1
o 9isk :ree Bonds:
;o0ina& 9ate= 9ea& ,nterest < ,n+ation
9ea& interest is the nu0ber you=d -o (ro0
consu0in- .s# spendin-#
8i-her interest rate: sa.e
o 9isky Bonds:
;o0ina& 9ate = 9ea& ,nterest < ,n+ation < 9isk
pre0iu0
6ou take 0ore risk when [Link]- in co0panies
.s# the -o.ern0ent
/hat kind o( risk pre0iu0s do we ha.e1
$i0e
>ua&ity/Credit/De(au&t risk
6ie&d Spread
o *easure o( return between co0panies or -o.ern0ent#
6ie&d Cur.e
o ;or0a&
o :&at
o ,[Link]
?arious 6ie&d *easures
o 6ie&d to *aturity @6$*A: $he discount rate that equates the
cash +ows and the current price o( the bond#
o 6$* has two assu0ptions that are questionab&e:
'ssu0es that you are -oin- to ho&d the security ti&& it
0atures#
'ssu0es that current interest rates [Link] chan-es
$his is ca&&ed rein.est0ent risk
Diference between stocks and bonds:
Stocks:
o :or -rowth [Link]
o [Link]-e B:1
Buy B stocks, on&y spend 51
Bonds:
o Steady inco0e (or [Link].e
o $o reduce the risk
o )rice appreciation (or short%ter0 specu&ators
o [Link]-e @1!:1A
Buy 1! bonds, on&y spend 51
Bond Yields
6ie&d to *aturity
o Ca&cu&ated before you purchase the bond
o *ost do0inant yie&d
Current yie&d: current coupon you recei.e/current price o( the bond
o Error: Doesn=t inc&ude price appreciation
9ea&iCed co0pound yie&d
o Ca&cu&ated yie&d after the bond 0atures
8oriCon yie&d
o *ake assu0ptions &ike: chan-in- interest rates
Types of Bonds
'cti.e:
o EDpensi.e eDpense ratio
o 8a.e to &ook (or where the interest rates are -oin-
)assi.e
o Cheaper eDpense ratio
o ,ndeD
o E$:
Bond buyers:
8ate in+ation
o.e econo0ic weakness
o.e Enancia& crises
o $he +i-ht to sa(ety: peop&e rush to the sa(ety o( the
-o.ern0ent when there are Enancia& crises in the 0arket
Bond Path:
)u&&ed to par: $he prices near the end are pu&&ed to the par .a&ue
Cash +ows:
o Coupon
o )rincipa&
o ,nterest on interest
/e -et 0ost o( our 0oney (ro0 the co0poundin-
Duration: a bond=s price [Link] to chan-es in interest rates

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