Key Terms to Know Before Investing in Bonds
Bonds are seen as difficult due to some of the terminology involved with this transaction. But, in reality, they are simply debt market investments (To know about what are bonds and debentures, refer to this interesting article). Some of the jargons involved with bond investments may be confusing to a rookie bond investor. We’ve compiled a collection of the most significant bond jargon that you should be aware of and consider before making an investment decision.
Coupon
A coupon payment is the amount of annual interest that a bondholder will receive on an annual basis. The coupon payment per bond unit is as follows:
Coupon Payment = Bond Face Value X Bond Coupon Rate in percent
This amount will be paid on a predetermined schedule – monthly, quarterly, biannually, or annually – until the maturity date.
Face Value
The face value of a bond is the designated value per unit when the bond is issued by the bond issuer. The face value of most bonds in the Indian bond market is Rs.1000.
Market Value
A bond’s market value is the price at which it is currently being purchased and sold in the market. This occurs after the bond is issued at face value. A bond’s market value might be either higher or lower than its face value. The value is determined by the overall economic conditions, the situation of the bond issuer’s industry, and the bond issuer’s business health.
Bond Issuer
The bond issuer is the bond issuing firm or borrower who sells bonds with the promise of regular interest payments and principal repayment at maturity. Bondholders are lenders who give money to bond issuers in exchange for bonds.
Payment Frequency
Bond payment frequency or payment schedule refers to the dates on which bond issuing firms pay interest to bondholders. Payments can be made monthly, quarterly, biannually, or annually. The bondholder might change some payment dates.
Maturity
The bond issuing company agrees to pay back the principal amount of the bond to the bondholder on a pre-defined date. This is called the bond maturity date. Once the principal amount is returned, the bondholder stops receiving the interest payments as well.
Example:
Assume an investor puts Rs 950 (market value) into a bond. The bond’s many parameters are as follows:
Face Value per unit = Rs 1000; Coupon Rate = 10%; Payment Period = 5 years on April 30th.
The investor will receive the following payments:
Every year on April 30th for the next five years, pay Rs 100. When the bond matures in the fifth year, the investor receives the face amount of Rs 1000.
Then his effective returns or yield to maturity will be around 11.352%.
The effective annual returns help in making a realistic comparison of different rates of returns of bonds. For example, if a bond receives a quarterly payment of interest, then due to compounding the effective annual returns will be higher than the actual interest returns.
Rating
A bond rating is a letter grade assigned to a bond based on its creditworthiness. The ratings might range from AAA to AA to A and below. AAA is the highest rating, and bonds having this rating are typically thought to be the safest.
In India, investment-grade bonds or safe bonds are defined as any bond with a credit rating of BBB or higher. Rating agencies assign this rating to the company (bond issuer) based on the bond issuer’s numerous financial variables. The issuer’s historical financial strength or ability to repay the principal and interest on time are two of the most usually evaluated considerations.
Conclusion
While bonds are a basic investment option, knowing the financial terms related with them will give you more confidence in your investment decisions.
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