A bond is an IOU issued by a corporation, government, or governmental agency to cover money the bondholder has lent. If you own stock in a company, you are a part owner of the company. As a bondholder, you are a creditor.
Bonds play a critical role in our economy and an important role in every well-balanced portfolio. Returns from bonds are generally lower than stocks; however, they're a much safer investment. Bonds' safety and stability act as a counter to the fluctuations common to stocks.
Lemon Fundz helps you pick the right bonds, at the right time to benefit the most from them!
Basic Bond Concepts
There are three basic concepts that will help you understand bonds:
Par value : Par value, also known a face or principal value, is how much the bondholder will receive at maturity. A Rs. 1,000 par value bond will be worth Rs. 1,000 when it matures.
Coupon : Coupon is the interest rate the bond pays. This interest rate does not vary over the life of the bond, although there are some bonds, which have a variable interest rate tied to an external index.
Maturity : Maturity refers to the length of time before the par value is returned to the bondholder. It may be as short as a few months, 50 years, or more. At maturity, the bondholder receives the par value of the bond.
Yield :
- Nominal Yield : This is the coupon or interest rate. Nothing else is factored in to this number.
- Current Yield : The current yield considers the current market price of the bond, which may be different from the par value and gives you a different return on that basis.
- Yield to Maturity : Yield to Maturity is the most complicated, but the most useful calculation. It considers the current market price, the coupon rate, the time to maturity and assumes that interest payments are reinvested at the bond's coupon rate.
Types of Bonds
- Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds.
- Floating Rate Bonds
In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.