- Investing in bonds: What is a Bond?
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What is a bond
Long term debt instrument in which borrowers agree to make payments of principals and interests to holders
Long term debt instrument: How long is long?
The time it takes a savings bond to reach face (par) value depends on the series of bond and the value at which it was sold. There are presently three different series of U.S. savings bonds. Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.
Characteristics of Bonds
We have fixed features on a bond certificate
Par Value- AKA face value, The worth of the bond upon maturity. It is also the base amount on which interest is calculated.
Coupon Interest rate- The interest rate on the bond paid by the issuers of the bond to the investors. Coupon payments are made annually or semi-annually.
Maturity Date- The date on which the bond issuer pays back the face value of the bond to the investor. It indicates repayment of the loan taken.
YTM-The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond’s yield to maturity rises or falls depending on its market value and how many payments remain to be made.
So essentially the coupon interest rate is fixed and the payout is constant, while the yield to maturity depends on the current price of bond and how many payments to be made.
Required Rate of Return
The required rate of return (RRR) is the minimum return an investor will accept for owning a company’s bond, as compensation for a given level of risk associated with holding the bond.
Interest rates is calculated by adding risk-free rate of interest, inflation premium, default risk premium and liquidity premium
Essentially we are adding the interest percentage that could be gained by investing excess funds in a risk-free investment to other investment risk premiums like inflation.
Total return identity- How to tell if a bond is overvalued or undervalued
Required return and expected return are similar to each other in that they both evaluate the levels of return that an investor sets as a benchmark for an investment to be considered profitable.
The required rate of return represents the minimum return that must be received for an investment option to even be considered.
Expected return, on the other hand, is the return that the investor thinks they can generate if the investment is made. If the security is valued correctly the expected return will be equal to the required return and the net present value of the investment will be zero.
However, if the required return is higher than the expected rate the investment security is considered to be overvalued and if the required return is lower than the expected the investment security is undervalued.
- Date of publication:
- Wed, 10/13/2021 - 20:36
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