6.1: Characteristics of Bonds
- Page ID
- 150184
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)A bond is a loan contract between an issuer and investors (bondholders). The issuer promises periodic interest payments (coupon payments) and repayment of principal (par value or face value) at maturity. Bonds trade in the capital markets, allowing issuers to raise long-term funds and investors to earn income with varying levels of risk.
Although bonds vary widely across issuers and markets, they share a common economic structure: a clearly defined set of future cash flows. Once these cash flows are identified, bond valuation becomes a structured application of the time value of money principles developed in Chapter 5.
Key Terms
- Par (Face) Value: The principal amount repaid at maturity (often $1,000 for corporate bonds). Par value determines the size of the final cash flow and serves as the base for calculating coupon payments.
- Coupon Rate: The stated annual interest rate on the bond (for example, 6%). Coupon payment = coupon rate × par value. The coupon rate is fixed at issuance and does not change over the life of the bond.
- Coupon Frequency: How often coupon payments are made (for example, semiannual or annual). In U.S. markets, most bonds pay coupons semiannually.
- Maturity: The remaining time until par value is repaid. Longer maturities generally imply greater exposure to interest rate risk.
- Price: The market value of the bond today. Bond prices are determined by discounting future cash flows at the required market yield.
- Yield: A measure of return based on price and promised cash flows. Common measures include current yield and yield to maturity (YTM). In formulas we often denote yield as y; on calculators this is entered as I/Y.
- Indenture and Covenants: The legal contract and provisions that define bondholder rights and issuer obligations.
- Credit Rating: An assessment of issuer default risk, commonly ranging from investment grade (AAA, AA, A, BBB) to speculative or high-yield (below BBB).
Bond Cash-Flow Timeline
Bondholders receive periodic coupon payments during the life of the bond and the par value at maturity. The timeline below illustrates a typical semiannual coupon bond.
TIP: Before you touch your calculator, write the timeline. Most bond errors are not math errors; they are setup errors (wrong number of periods, wrong periodic rate, or coupon timing).
Common Types of Bonds
Table 6.1 — Common Types of Bonds
| Type | Typical Issuers | Key Features | Why Investors Buy |
|---|---|---|---|
| Treasury Bonds, Notes, and Bills | U.S. federal government | Very low default risk; highly liquid; benchmark yields | Capital preservation, safety, portfolio anchor |
| Municipal Bonds | States, cities, public agencies | Often tax-advantaged interest; general obligation or revenue-backed | After-tax income and community investment |
| Corporate Bonds | Public and private corporations | Varied credit risk; covenants; may be callable or convertible | Higher yields to compensate for credit risk |
| Zero-Coupon Bonds | Government or corporate issuers | No coupons; issued at a discount; single maturity payment | Long-term planning and interest rate sensitivity |
| Convertible Bonds | Corporations | Option to convert into equity; lower coupon than similar bonds | Equity upside with bond downside protection |
| Inflation-Protected Bonds (e.g., TIPS) | U.S. Treasury and others | Principal adjusts with inflation (CPI) | Real return and purchasing power protection |
Real-World Example: Apple Inc. Corporate Bond Issuance
Large, highly rated corporations frequently raise long-term financing through the bond market by issuing multiple bonds at the same time, each with different maturities and coupon rates.
