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9.1 Bonds and Interest Rates

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Explain what a bond is and who issues bonds.
  2. List and describe the key features of a bond.
  3. Calculate the coupon rate given the annual coupon payments and the par value of a bond.

In this chapter, we will focus on bond instruments, which are one way to securitizeTo make a series of cash flows into a tradable instrument. (to make a series of cash flows into a tradable instrument) a loan. A bondA loan packaged as a tradable security, typically with a periodic interest payment and a repayment of principal at maturity. is a loan packaged as a tradable security, typically with a periodic interest payment and a repayment of principal at maturity.

Who Issues Bonds?

There are many different entities that will issue bonds, and often bonds will behave differently based upon the type of issuer. At an investment bank, bond traders will often specialize in trading one type of bond. Here are some of the more common:

  • Corporation = Corporate Bonds or “Corporates”
  • US Government = Government Bonds or “Govies”
  • Smaller Government Entities (e.g. Cities or States) = Municipal Bonds or “Munies”
  • Other Governments = Sovereign Bonds or “Sovereigns”

Bonds originally were pieces of paper, stating all of the necessary information in the center with coupons (yes, just like the Sunday paper!) around the edge. The owner of the bond would cut off the coupon and turn it in to receive each periodic interest payment. The terminology stuck, so even with today’s electronic bonds, the periodic payments are called coupon paymentsThe periodic payments of a bond, typically paid semiannually.. Most bonds pay these coupon payments twice a year (semiannually), though once a year (annual) payments are not uncommon.

These coupon payments typically occur until the maturity dateThe date on which the final coupon payment and the principal of the bond is due., at which time the final coupon payment and the principal of the bond would be due. This principal amount is called the par valueThe pricipal amount of the bond.. Currently, the most common par value for corporate bonds in the USA is $1,000. When describing a bond, we typically list the coupon rateThe annual total of the coupon payments expressed as a percentage of the par value., which is the annual total of the coupon payments expressed as a percentage of the par value.

For example, a bond which pays $50 semiannually would be paying a total of $100 ($50 × 2) every year. If the par value of the bond is $1,000, then we say that the bond has a coupon rate of $100 / $1,000 = 10%.

Equation 9.1 Coupon Rates

Annual Coupon Payments ÷ Par Value = Coupon Rate
Coupon Rate × Par Value = Annual Coupon Payments

Coupon Rate vs. Interest Rate

It is very easy to confuse the coupon rate with the interest rate. The key item to remember is that the interest rate can change over time (as the price of the bond fluctuates), but the coupon rate for most bonds is established at the time of issue and typically doesn’t change over the life of the bond. To make things more confusing, companies typically like to issue the bonds with the coupon rate being close to the prevailing interest rate! But just remember that, once the coupon rate is set at the time of issue, it doesn’t change.

There do exist bonds that having “floating” coupon rates which can change, but they are the exception and not the rule. In this book, we will always assume that bonds are standard bonds with fixed coupons.

All bonds are governed by a bond indentureThe contract which stipulates all of the sepcific details of a bond, including conditions for repayment and default., which is the contract which stipulates all of the specific details of the bond, including conditions for repayment and default, when bondholders can usually seek legal recourse for greater control of the company. Specific items in the bond indenture are referred to as covenantsSpecific items in a bond indenture..

Key Takeaways

  • Bonds make coupon payments until the maturity date, at which point the final coupon payment and the par value are due.
  • The coupon rate is the annual coupon payments of the bond divided by the par value of the bond.
  • Coupon rates don’t change over the life of the bond for almost all bonds.

Exercises

  1. List the key features of a bond and what they represent.
  2. A typical bond is issued with a 5% coupon. If interest rates change to 6%, what happens to the coupon for this typical bond?