If you follow the bond market, you can observe that prices of bonds are generally decreasing when the economic news are good and increasing when negative. An understanding of this typical valuation of bonds can explain the phenomena.
After reading this document, you will know how bonds are defined, valuated and traded. There are ts to bondholders makes bonds a good and safe investment: investors get fixed amounts of incomesfundamental factors that generate fluctuations in prices of bonds. knowing these factors leads to a better understanding of the underlying economic forces together with the valuation of bonds.
Main features of bonds
A bond is a negotiable debt security under which the issuer borrows a given amount of money, called the principal amount. In exchange, the borrower agrees to pay fixed amounts of interests, also called the coupons, during a specific period of time. Everything is well defined by the bond contract: the coupon rate is the interest rate that the issuer pays to the bondholder and the coupon dates are the dates on which the coupons are paid. Besides the issuer will repay the total amount of the principal when the bond will reach what is called maturity (or maturity date).
In short, a bond is a securitized loan.
First, we can mention the most relevant point that makes bond so attractive, especially in gloomy periods for stock markets. Indeed, the regular payments of interes and are repaid the principal value at maturity date. Bonds with maturity of one year or less are referred to as short-term bonds or debt.
Bonds with maturity of one year to ten years are referred to as intermediate bonds or intermediate notes. The long-term bonds are issued with a maturity of at least ten years and commonly up to 30 years.
A second important aspect is that all characteristics of bond are well defined in advance and the market offers different choices for each of them: coupon rate (also called coupon yield), coupon date, maturity date can vary from one bond to another but are known when investing into the given bond. It allows the investor to fit its investment strategy with its risk and return acceptable levels.
Let consider the following example: for a bond with a principal value of 1000 $, a yearly coupon rate of 5% and a maturity of 2 years. As the yearly coupon rate is 5%, the issuer of those bonds agrees to pay $ 50 (5% x $ 1000) in annual interest per bond. The second year, the bondholder will receive (per bond) 50 $ + 1000 $, the coupon and the repayment of the principal value. I is exactly what you can expect if you have bought the bond as defined in this example and if the issuer of the bond is not in default!
However, at each instant, the value of your bond may fluctuate. Imagine that the market interest rate is raising to 6% in the second year of your bondholding and new bonds …