Bonds

Definition

Bonds are debt securities issued by corporations, governments, or other entities to raise capital. When investors purchase bonds, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value upon maturity. Bonds play a crucial role in personal finance, corporate finance, and public finance as a way to secure funding.

5 Must Know Facts For Your Next Test

1. Bonds can be categorized into several types, including corporate bonds, municipal bonds, and treasury bonds, each serving different purposes for issuers and investors.
2. The face value of a bond is the amount paid back to the bondholder at maturity, which is usually set at $1,000 for corporate and government bonds.
3. Interest from municipal bonds is often exempt from federal income tax, making them attractive investments for individuals in higher tax brackets.
4. Bond prices are inversely related to interest rates; when interest rates rise, existing bond prices tend to fall and vice versa.
5. Bonds are considered less risky than stocks but typically offer lower returns over time, making them an essential part of a diversified investment portfolio.

Review Questions

• How do bonds function as financial instruments within personal, corporate, and public finance?
  • Bonds serve as important financial instruments across personal, corporate, and public finance by providing a mechanism for raising capital. Individuals use bonds as part of their investment portfolios to earn fixed income over time. Corporations issue bonds to fund expansion projects without diluting ownership through equity financing. Similarly, public entities issue bonds to finance infrastructure projects or manage budget deficits while benefiting from investor capital.
• Discuss how the concept of time value of money is applied in bond valuation and pricing.
  • The concept of time value of money is integral to bond valuation and pricing because it reflects how future cash flows from interest payments and principal repayment are discounted back to their present value. Investors assess the worth of a bond based on its expected cash flows compared to what could be earned through alternative investments. The present value calculation incorporates factors such as the coupon rate and yield to maturity, helping investors make informed decisions about whether a bond is fairly priced relative to its risks and expected returns.
• Evaluate the relationship between bonds and risk-return trade-offs within an investment portfolio.
  • The relationship between bonds and risk-return trade-offs is crucial for constructing an effective investment portfolio. Bonds typically offer lower returns than stocks but come with reduced risk, providing stability in times of market volatility. By allocating a portion of a portfolio to bonds, investors can achieve diversification that mitigates overall risk while still generating income through coupon payments. Furthermore, understanding credit ratings helps investors assess the risk associated with different bonds, allowing them to make strategic choices based on their risk tolerance and investment goals.

Related terms

Coupon Rate: The interest rate that the bond issuer pays to bondholders, usually expressed as a percentage of the bond's face value.

Yield to Maturity (YTM): The total expected return on a bond if it is held until maturity, factoring in the bond's current market price, coupon payments, and time remaining until maturity.

Credit Rating: An assessment of the creditworthiness of a bond issuer, indicating the likelihood that they will default on their debt obligations.