What is a bond?
A bond is a type of debt security issued by governments,public authorities, companies and credit institutions to raise the finances andin return pay a certain amount of interest (also called the coupon) eitherfixed or floating and/or pay the principal value narrated on the bond on thematurity, depending upon the agreed terms of bond. The interest is paid back tothe investor after fixed time periods; semiannually, annually or as agreed.
Some bonds do not pay the interest but are issued at discount and are redeemedat the narrated par value; they are named as zero coupon bonds. Mostly bondscan be transferred to other persons but some issuers may not allow this.
Usually, different institutions and funds like insurance companies,banks and pension funds etc. make investments in the bonds. The investingentities, during the life of bond, face different types of risks and theinterest rates proposed to the investors are risk free rate plus the premiumfor risk. Bonds are usually of two types; perpetual bonds (Also called consol,bonds having no maturity date) and bonds with a maturity date from one year tomore than twelve years (Two further types; non-zero coupon bonds and zerocoupon bonds).
Difference between Bonds issued by Governments and Companies:
Governments issue the bonds to get funds for thecountry’s development projects or to pay off the governments debts. While thecompanies issue bonds to raise funds for their business expansions or for thepurpose of refinancing.
Bonds in developing countries are more popular asgovernments issue bonds to get finances and investors get high return due tothe relatively lower credit rating of developing governments. While investingin bonds issued by the private companies get a priority as the due interests and principal amounts are paid to the investors before all other creditors and liabilities.
Bonds issued by governments are theoretically risk free due to minimumrisk of default of governments and hence the coupon rates are lowest of allother bonds. While, bonds issued by private companies have relatively highercoupon rates due to a relatively higher risk of default.
How to calculate Bond Yield?
Bond yield is an amount that shows the return, an investorgets on a bond. Generally, the bonds yield is calculated according to theirmaturity time period, i.e. perpetual or have a maturity date. The valuation of a bond depends upon its;
•Coupon rate and
•Time to maturity
A simple formula that can be used to calculate the yield for a perpetual bond is;
Bond Yield=”coupon” amount/ market price of the bond
There is another concept in the calculation ofbond yield is yield to maturity that is quite complex and difficult to understand.