Characteristics of Bonds I

Introduction to Fixed Income Securities

Fixed income securities, like bonds, are debt instruments issued by governments, corporations, and other entities to raise capital.

Igor, planning to buy a home in five years, explores bonds to grow his $50,000 savings for a down payment.

With bonds, Igor aligns his timeline, earning interest while ensuring he’ll have his principal back for his future purchase.

In this lesson, we'll explore core characteristics of these securities to understand how they function and fit into an investment portfolio.

Understanding Principal

The principal, or face value, is the foundation of any bond. It represents the amount the issuer agrees to repay to the bondholder at maturity.

This figure is crucial for calculating interest payments and determining the bond’s overall value.

For example, a bond with a $10,000 principal means the investor lends $10,000 to the issuer.

Knowing the principal helps investors plan for both the income they’ll receive and the return of capital when the bond matures.

The Concept of Interest

Interest is the income investors earn from lending money to issuers of bonds.

It compensates for the time value of money and credit risk. Bonds generate this income through regular interest payments, providing predictable cash flow.

Interest can be fixed or floating: fixed interest remains constant throughout the bond's life, while floating interest rates adjust periodically based on a benchmark rate plus a margin.

Understanding interest is essential for evaluating bond investments.

Fixed and Floating Coupon Rates Explained

Building on the concept of interest, the coupon rate specifies the annual interest payment as a percentage of the bond’s principal.

In fixed-rate bonds, the coupon rate remains constant, providing stable income, e.g., a bond with a 4% fixed coupon rate and a $1,000 principal pays $40 annually.

Floating-rate bonds have coupon rates that adjust at set intervals based on a reference rate (like the Fed Funds Rate) plus a margin.

This means interest payments can change.

Igor Learns About Coupon Rates

Eager to invest, Igor researches a corporate bond issued by SolarWave Industries.

The bond has a face value of $50,000 and offers a fixed coupon rate of 4% per year, meaning he'll receive $2,000 in interest annually.

He also finds another bond from the same company with a 5% coupon rate but notices it matures in 10 years, beyond his five-year goal.

Understanding how the coupon rate affects his income, Igor opts for the 4% bond that aligns with his timeline, balancing return and accessibility.

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