1. Advanced Bond Concepts: Introduction
  2. Advanced Bond Concepts: Bond Type Specifics
  3. Advanced Bond Concepts: Bond Pricing
  4. Advanced Bond Concepts: Yield and Bond Pricing
  5. Advanced Bond Concepts: Term Structure of Interest Rates
  6. Advanced Bond Concepts: Duration
  7. Advanced Bond Concepts: Convexity
  8. Advanced Bond Concepts: Formula Cheat Sheet
  9. Advanced Bond Concepts: Conclusion

In the Bond Basics Tutorial, we covered introductory concepts. In this tutorial, we’ll review a few ideas and then move onto advanced bond concepts.

A bond is an IOU issued by a corporation or government in order to finance projects or activities. When you buy a bond, you are extending a loan to the bond issuer for a particular period of time. In exchange for the loan, the issuer pays you a specified interest rate (known as the coupon rate) at regular intervals until the bond matures. In general, the higher the interest rate, the higher the risk. When the bond matures, the issuer repays the loan and you receive the full face value (or par value) of the bond.

Here’s an example. Assume you buy a bond when it’s first issued that has a face value of $1,000, a 5% coupon and a maturity of 10 years. You’ll receive a total of $50 of interest each year for the next 10 years ($1,000 * 5%), and when the bond matures in 10 years, you’ll be paid the bond’s face value - $1000 in this example.

Bonds expose investors to several types of risk, including default, prepayment and interest rate risk.

Default Risk

The possibility that a bond issuer will not be able to make interest or principal payments when they are due is known as default risk. While many bonds are considered no- or low-risk (such as short-term U.S. government debt securities), certain bonds, including corporate bonds, are subject to varying degrees of default risk. Bond-rating agencies, including Fitch, Moody’s Investors Service and Standard & Poor’s, publish evaluations of the credit quality and default risk for many corporate bonds.

Prepayment Risk

The possibility that a bond issue will be paid off earlier than expected is known as prepayment risk. This often occurs through a call provision. Many firms embed a call feature that allows them to redeem, or call, the bond before its maturity date at a specified call price. This feature provides flexibility to retire the bond early if, for example, interest rates decline. In general, the higher a bond’s interest rate in relation to current rates, the greater the risk of prepayment. If prepayment occurs, the principal is returned early and any remaining future interest payments will not be made. As a result, investors may be forced to reinvest funds in lower interest rate bonds.

Interest Rate Risk

Interest rate risk is the possibility that interest rates will be different than expected. If interest rates decline significantly, you face the possibility of prepayment as firms exercise call features. If interest rates rise, you risk holding a bond with below-market rates. The longer the time to maturity, the higher the interest rate risk since it is difficult to predict rates farther into the future.

 

Bonds basics are fairly easy to comprehend – most people understand the concept of borrowing and lending money, after all. Like many securities, however, analyzing and trading bonds can get tricky. In this tutorial, we’ll cover some of the more complex aspects of bonds, including pricing and yield, duration and convexity. If you need a bond refresher before moving on, please see Bond Basics.

 


Advanced Bond Concepts: Bond Type Specifics
Related Articles
  1. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  2. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  3. Financial Advisor

    Advising FAs: Explaining Bonds to a Client

    Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
  4. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  5. Investing

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  6. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  7. Investing

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center