How do bonds work?

17th Nov 2009 by Michael Haltman

Bonds are called fixed income instruments, meaning that investor will more likely be buying them for dependable cash flow rather than price appreciation. Bonds will be sold to the market by an issuer, be it a municipality, federal government or a corporate entity. The typical bond issue will offer different maturities, usually from 1 to 10 years and then term bonds of 20 an 30 years. This structure is not written in stone and every bond issue can be different. Most issuers will get their bond rated as that makes it easier to sell, particularly to institutions. Each maturity will have a coupon, or the amount that it will pay the investor buying it on a yearly basis. They are mostly issued at par or 100, but can also be issued at a discount or premium which will make the yield higher or lower. Shorter maturities will offer lower yields that longer maturities, and longer maturity bonds will often have call provisions meaning that the issuer can buy the bonds back before the stated maturity.

The cardinal rule of bonds is that prices move inversely to yield. As prices go down yields go up, and as prices go up yields go down. Price volatility is a function of premium or discount price, maturity, and coupon.

This answer is the subjective opinion of the writer and not of FinancialAdvisory.com