The intent of this paper is to define what bonds are as a vehicle for investors including a detailed explanation of the basic terms associated with bonds, the different types of bonds available in the markets, bond ratings, and why investors might want to consider bond investing to have a more diversified portfolio. Finally, the paper will discuss the relationship between bonds and interest rates in determining bond valuations. Following the discussion there will be a brief summary of the main points explained throughout the paper.
Everyone in the investment world is constantly looking for ways to insulate themselves from the volatility surrounding the markets in terms of strategizing investments and diversification. Most investors look to the markets for common stock options and mutual funds with hesitancy to global volatility facing today’s financial markets. Another investment market option to considered, although not immune to outside volatility, is the bond market. Ross stated the bond market is larger in scope than the stock market (2011). A bond is an investment option wherein the investor loans money to large organizations such as corporations, state and local municipalities, the US government and governments abroad (Parker, 2014). The Securities and Exchange Commission (SEC) classify a bond as a debt instrument. The bond, also known as a debt security, is issued to the public (creditor) who holds the bond until they are repaid by the borrower in interest-only payments over a particular period (Ross, Westerfield and Jordan, 2011). At the end of the bond term and only then is the principal of the loan paid in full as a balloon payment. It is similar to an IOU held by the creditor until the borrower fulfills their promise to repay the loan back with interest (Parker, 2014).
In bond investing there are a few basic terms to be understood such as: bond coupons, face value, par value, coupon rate, and maturity. A bond’s coupons are vouchers attached to the unregistered bond also called a bearer bond (Investor Words, 2014). These coupons are presented to the borrower for an interest-only payment to the lender annually or semi-annually for each payment term until the end of the payment period. This type of coupon is referred to a “level coupon bond” because it pays the same amount to the lender at each pay cycle (Ross, Westerfield and Jordan, 2011). To calculate the coupon payment for a 30 year term the interest rate in this case at 7 percent at which the bond is issued is multiplied by the face value of the bond which is $1000 to get the annual interest-only payment of $70 for the 30 year term totaling $2,100. This is calculated in the example below:
.07 x $1,000 = $70 x 30 = $2,100 at the end of the payment period
This method of payment is now being replaced by registered bonds which have their interest payments sent directly to the “registered owner” (Parker, 2014). The face value of a bond is its value that is paid at...