Understanding bonds

Bonds is one of the three main asset classes besides stock (equity) and cash equivalents. Bond is considered fixed income security where bond issuer is in debt to the bond holder and is obliged to pay him an interest. It can be understood as a form of a loan where holder of the bond is creditor, issuer of the bond is borrower and coupon is interest that he pays. Issuers of the bonds are companies, municipalities, states and governments which used funds obtained through bonds to finance long term investments and current expenditures.

Bondholders are debt holders that have priority over stockholders but are ranked behind secured creditors in case of insolvency.

Bonds have maturity date when the principal is due to be paid and interest rate that can be fixed or variable. Principal is face value of the bond, actual amount that is on the bond which will be paid to the holder at the maturity date. Fixed rates remain the same through the set period while variable rates fluctuate over time because they are based on a benchmark that changes periodically. Interest rates are paid in regular intervals, usually semiannually. The bond principal is not the same as its price. It can be purchased far more or less than its principal. Because fixed interest coupon bonds pay the same percentage of face value bond's appeal on the market will depend on prevailing interest rates. If the interest rates have risen bonds trade at discount and if they have fallen bonds trade at premium price meaning that bond market moves inversely with interest rates.

Various factors affect bond market price, amount and timing of of the interest payment, quality of the bond, the credit quality of the issuer, length of time until maturity etc. If issuers has poor credit rating or long maturity rates coupon rates are higher because there are higher chances of default and bondholders are more exposed to risk of changing interest rates. Bondholders can sell them to another investors as bond can be traded on exchange, over the counter market (OTC) or privately. Also bond issuers can repurchase the bonds if they improve their credit rating or if interest rate decline so they can issue new bonds with lower rates.

There are three main categories of bonds issued by the US Government classified by their length of maturity. Bonds issued with a year or less to maturity are called bills, bonds issued with 1-10 years to maturity are called notes and with maturity length above 10 years are called bonds.

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