Question

Explain the basic attributes of bonds; how are bonds priced in the market and why some bonds are more volatile than others

​IN DETAIL

Answer 1

bonds are kinds of debt instruments where the debt holder is the creditor and the issuer of the bonds is the debtor.

the rate of return that the bond holder receives is the yield to maturity of the bond. the issuer pays coupons on bonds which is paid either semi annually,annually or quarterly. the issuer of the bonds,have to pay the interest or the coupon payments as well as repayment of the nominal amount of the bond as well.

the main difference between a bond holder and the stock holder is that bond holders, are a specific period of time invested in the company,whereas a stock holder is a part of the company forever. except for bonds held till perpetuity, a bond holder remains invested with the company for a specified period of time as mentioned in the bond contract.

the payments made on the bonds depends on the quality of the bonds. the high yield bonds generally are rated below the investment grade and there exist a risk of default in these bonds. hence, these bonds generally pay a higher yield.

government bonds are generally the safest and there exist no risk of default. next are the corporate bonds.

AAA bonds are investment grade bonds which are generally safe and offer lower yields in comparison to the junk bonds/high yield bonds.

two types of bonds :

callable bonds : these bonds give the issuer the right to repay the bond before the maturity date. As the interest rate falls, the bonds are called by the issuer and finances at the lower rate of interest.

these bonds expose the bond holders to reinvestment risk,as the bond snow have to be invested at lower rates than before.

putable bonds : these bond gives the bond holder the right to ask the issuer to repay the bond before the maturity date.

a bond has a par value which is usually $100,$1000

coupon rate : which is a percentage of the par value of the bond

ytm= which is the rate of return on the investment that the bond holder receives

time period during which the bond is held till maturity.

the present values of all the coupon payments are then added up to get the present value of the bond.

coupon payments are :5% *1000 = $50

time period = 3 years

fv = $1000

ytm = 3.5%

PV OF BONDS : 50/1.035 + 50/1.03^25 + 1050/1.035^3

= 48.31 + 46.67 + 947

= $1042.02

the bond is trading at a premium in the market, as the coupon rate is more than the yield to maturity.

some bonds are volatile than the others :

• 1. bonds are exposed to interest rate risk. as the interest rates rises the prices of bonds fall. as the time to maturity increases , the volatility of the bonds increases. the more is the changes in the prices of bonds due to the changes in interest rates.

as the interest rate rises, the present value of the principal and coupon payments fall. the longer the time till maturity, the more the prices will fall.

• bonds with higher credit ratings are less volatile to the changes in the interest rates , than the bonds with a lower credit ratings.
• bonds with higher yield are less volatile than the bonds with a lower yield . as the bonds with a higher yield are called cushion bonds , the higher yield already provides a cushion against the falling interest rates as compared to the bonds with lower yields.