In the thread on the explanation of the national debt, forum member byron84 asked some fundamental questions about bonds. In this post, I will try to clarify some of the basic terminology and mechanics of how bonds work. If I make any mistakes, please correct me.
A bond is basically a big loan broken up into tiny identical pieces. When a corporation or government wants to raise a lot of money in the capital markets, they can issue bonds and sell them to investors. A bond is a legal obligation in which the borrower agrees to pay coupons to the investors at fixed intervals until the bond matures. On the date that the bond matures, the borrower will redeem the bond and pay the investor the face value of the bond. The redemption of the bond ends the legal obligation of the borrower to the investor. Unless the bond has an embedded call option, bonds cannot be redeemed by the issuer prior to the maturity date.
Bonds can be very complicated instruments, since issuers and their advisors (investment banks) can tailor the suit their needs and those of the market. In the most basic type of bond, there are key characteristics as follows:
Maturity date - As was described above, this is the date that the bond issuer agrees to redeem the bonds and pay the face value to the bondholder. Typically it is also the date of the last coupon payment.
Face value - These days bonds are no longer issued as physical paper certificates, but in the olden days, every bond certificate had amount printed on it that indicated the amount of money the bond issuer agreed to pay the investor on the maturity date. It is common practice in North America these days for the face value of a bond to be in $1000 increments.
Coupon - In olden days, bonds had perforated sections referred to as coupons that could be torn off and redeemed for the agreed amount of coupon payment; these days this is all done electronically.
Coupon rate - The coupon rate is the ratio of coupon payment to the face value of the bond a 5% coupon bond with a face value of $1000 will make annual coupon payments of $50 during the year.
Coupon frequency - This is the number of times that coupon payments are made during the year. By tradition, in North America most bonds make two coupon payments per year. A $1000 face value bond with a 5% coupon rate making two payments per year will pay $25 twice a year at 6 month intervals. Not all bonds have the same coupon frequency though!
Yield-to-maturity and purchase price - I have put these two together because they are intimately related. The yield-to-maturity is the discount rate that is applied to all the future cash flows of the bond to determine the price. The yield-to-maturity represents the return the investor will earn assuming that the bond is held to maturity, that all coupon payments are reinvested at an equivalent interest rate, and that the bond issuer does not default. The price at purchase is the present value of all the remaining coupon payments and the face value discounted at the yield-to-maturity. The mathematics of discounting cash flows are best described elsewhere for now.
Yield and price - More generically, you might hear people talk about bond yields. The yield on the open market represents the lowest return that investors are willing to accept from purchasing that bond issue. The price of a bond on the open market is is equal to the present value of the future payments of the bond (coupons and face value) discounted at the prevailing yield for that bond issue. When the yield is equal to the coupon rate, then the bond price is simply equal to its face value (referred to as trading at par value). When the yield is above the coupon rate, the bond is trading at a discount, meaning that the current price is less than face value. When the yield is below the coupon rate, the bond is trading at a premium, meaning that the current price is above face value. Bond yields are influenced by a number of factors including prevailing interest rates, the creditworthiness of the bond issuer (i.e. expectation of default), and relative demand for bonds compared to other investments.
If you go to your investment advisor and inquire about purchasing a bond, they will probably call their institution's bond trading desk and ask at what price and yield the bond issue is being offered. Incidentally, bonds are traded in the over-the-counter market, between bond dealers, banks and other market participants - as opposed to stocks which are traded on relatively centralised exchanges. If you agree to purchase the bond at the quoted price and yield, then the bond trading desk will purchase the bond on the open market and place it in your brokerage account. The minimum amount of a bond purchase in Canada is typically $5000 of face value (if the bond is trading at a discount, then the purchase price will obviously be less than $5000) and in $1000 increments. Bond prices are usually quoted as an amount per $100 of face value. So a bond offered at 102 is trading at a premium, and the minimum purchase would be $5100.
If you purchase a bond between coupon payment dates, you will also have to pay for the accrued interest on the bond. Coupon payments are accrued daily until they are paid out on the specified payment date(s). The amount of accrued interest on the bond can be determined mathematically by taking the coupon payment amount, dividing it by the number of days that it accrues (for a bond with 2 coupon payments per year, this should be about 182.5 days) and multiplying by the number of days since the last payment. So for example, if you want to purchase $5000 in face value of bonds that pay 5% in coupons twice a year, and the bond is currently offered at 102, then you have to pay between $5100 and $5225 depending upon when the last coupon payment was made.
Selling a bond (prior to maturity) has a similar mechanic to purchasing a bond. If you tell your investment advisor you want to sell your bonds, they will call the bond trading desk, which will quote a bid price and yield. Using the example above, suppose you bought the bond quoted at 102 for about $5100 (on day after the last the coupon payment date). 9 months have passed, and you received one coupon payment of $125 in the interim. bond yields fell during this time and now your investment advisor says that the bond is being bid at 104. In this situation, when you sell the bond, you receive $5200 plus the amount of accrued interest (which should be about $62.50). The difference in prices of $100 is taxable as a capital gain, while the $125 coupon payment and $62.50 accrued interest are taxable as interest income.