Introduction to Bonds

When companies or governments want to raise money, one way they can do so is by borrowing money from the public by issuing bonds. A bond is simply a contract whereby the issuer borrows money today and promises to pay back that money with interest on a fixed schedule. While there’s a lot of variety in how bonds are structured in the real world, most bonds have the same basic structure.

The total dollar amount borrowed is called the Face Value or Notional of the bond. A typical bond will make semi-annual payments as a percentage of its notional called coupon payments until the bond matures. On the maturity date, the bond will make a final coupon payment and will pay back the entire notional of the bond, called the principal payment.

For example, consider a fictitious company Coyote Inc. that needs to raise $100,000,000 to expand its business. It issues $100,000,000 of bonds to investors that pay a 10% coupon semi-annually and mature 10 years from now. You as an investor decide to buy $1,000 in notional of this bond from Coyote. You should expect to receive (10%)($1,000) = $100 every year paid out in two $50 payments every six months and the full $1,000 with the final coupon payment in the end of ten years.

bondsimpleexample

Note that if you simply discount the bond cash flows by the risk-free rate, say 2% semi-annually compounded, you would find that the their present value is actually $1,721.82, much higher than the $1,000.00 that you paid.

\displaystyle \frac{\$ 50}{\left(1+\frac{02}{2}\right)^{.05\times 2}}+ \cdots + \frac{\$ 1,050}{\left(1+\frac{.02}{2}\right)^{10\times 2}} = \$ 1{,}721.82.

If this were a risk-less bond, like a U.S. government bond, then that would be an appropriate way of computing a fair value for the bond. However, Coyote Inc. is  not the U.S. government and could go bankrupt before the bond matures in ten  years. If that happens, you may end up receiving only a small fraction of the principal payment you are owed. Therefore, investors would only be willing to buy this bond if they could buy it for much cheaper than $1,721.82, in this case $1,000.00.

Once bonds have been issued, investors are free to sell their bonds to other investors willing to buy them. However, as the bond markets move up and down, and as the financial health of Coyote Inc. changes, so will the amount investors are willing to pay for this bond. Let’s leave Coyote Inc. now and look at a real-life examples.

Coca-Cola and Netflix

We can find up-to-date market data as well as historical trading data on most bonds for free at the FINRA website.1 If we search for Coca Cola, we’ll find that it issued a bonds over the last few years. Here is one of those bonds:

Screen Shot 2017-03-05 at 10.10.22 AM.png

In this entry, you’ll see that this bond was traded on 03/03/2017 at $93.42. Bond prices are generally quoted as a price per $100 of notional, so $1,000 of notional of this bond would cost you only $934.20.2 Since this bond is trading below $100 (trading below par), this bond is said to be trading at a discount. This means that investors are no longer willing to earn only 2.5% on their investment in Coca Cola because of changes in Coca Colas financial health or overall market conditions. Now let’s take a look at a bond issued by Netflix.

screen-shot-2017-03-05-at-10-25-12-am

This bond traded at $108.00 on 03/03/2017, well above par, and is therefore trading at a premium. This indicates that investors are attracted to the bonds high coupon and are willing to pay even more for that coupon given changes in Netflix’s financial health or market conditions.

 

 

 


  1. For more information on TRACE market data from FINRA, visit www.finra.org/industry/trace
  2. It’s also common to quote bond prices as cents per dollar of notional, so you might hear that this bond is trading at 93 cents.

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