A bond is basically a security that provides an investor with a series of fixed interest payments over its tenure, including a fixed principal payment when it matures. It is the capital market instrument used to raise debt capital from the open market. Simply put, a bond is a loan taken at a certain interest rate for a certain amount of time and repaid on maturity. The most common bond type is Straight Bond.
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Overview of the Straight Bond:
A Straight bond is a bond that pays interest at regular intervals and whose principal is entirely returned to the borrower when the bond meets its maturity date at the end of the bond duration. The fixed amount paid at maturity is described as the principal of the bond, the par value, the stated value, or the face value. The periodic payments of interest are called coupons. The perfect example of straight bonds is the U.S. Treasury bonds to fund the national debt issued by the federal government. Business firms and municipal governments, however often regularly issue debt in the form of straight bonds. It is also considered as a plain vanilla bond because it has no additional characteristics that other categories of bonds may have. A straight bond doesn’t have any embedded options. Many bonds have additional special features in addition to a straight bond component. Often these features are intended to optimize the value of a bond to investors. Convertible bonds, for example, have a conversion feature that allows bondholders the flexibility to transform their bonds into common stock of the issuing company. It is only necessary to understand that, when a bond is released with one or more unique provisions, it is no longer a straight bond.
The value of a straight bond is determined by the extent and changes in the interest rate. If interest rates increase, the price of the bond will fall, and vice versa. This inverse relationship between bond yields and interest rates derives directly from the existing bond price relationship. A Straight bond’s price is generally calculated taking into the present value of all future cash flows. The present value of a bond, expected to mature in N time periods, with coupons
every period can be calculated as follows:
P: present value of the bond
C: coupon of the bond
M: Face value at Maturity
I: Risk-free rate of Interest
The discount rate for estimation of the present bond value is will vary from bond to bond, based upon the default risk, with higher rates for risky bonds and lower rates for safer ones.
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Risk Involved in Straight Bond:
- Interest rate risk: When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. This is a risk if you need to sell a bond before its maturity date and interest rates are up. You may end up selling the bond for less than you paid for it.
- Inflation risk: This is the risk that the return you earn on your investment doesn’t keep pace with inflation. If you hold a bond paying 2% interest and inflation reaches 3%, your return is actually negative (-1%), when adjusted for inflation. You’ll still get your principal back when your bond matures, but it will be worthless in today’s dollars. Inflation risk increases the longer you hold a bond.
- Market risk: This is the risk that the entire bond market declines. If this happens, the price of your bond investments will likely fall regardless of the quality or type of bonds you hold. If you need to sell a bond before its maturity date, you may end up selling it for less than you paid for it.
- Credit risk: If you buy bonds from a company or government that isn’t financially stable, there’s more of a risk you’ll lose money. This is called credit risk or default risk. Sometimes, the issuer can’t make interest payments to investors. It’s also possible the issuer won’t pay back the face value of the bond when it matures.
Author: Divya Sankhla
Divya has completed her graduation in Bachelor of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She has a keen interest in learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.