Bonds A.P. Macroeconomics Ms. McRoy-Mendell

Bond Basics  Up to this point, we've talked about bonds as if every investor holds them to maturity.  In fact, they do not need to be. As a result many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any other publicly- traded security.

Bond Basics – Key Terms  Face Value (aka “par value” aka “principle”): The amount the investor receives when the bond matures.  Maturity: The date in the future on which the investor's principal and last coupon will be paid.  Coupon: Interest rate on the bond  Yield: (coupon rate/price) *100 or (par value – price)/price *100 for zero-coupon bonds.  Issuer: The organization issuing the bond.

Bond Basics – Key Terms  Zero-Coupon Bonds No coupon payments Derive value from the difference between price and principle paid at maturity.  Example:  If a zero-coupon bond is trading at $950 and has a principle value of $1,000, the bond's rate of return is 5.26% ([( ) / 950]*100 = 5.26%).

Bond Basics – Logic  For a person to pay $950 for this bond, he/she must be happy with receiving a 5.26% return.  But his/her satisfaction with this return depends on what else is happening in the bond market.  If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all.

Bond Basics – Key Terms  To attract demand, the price of the pre- existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. Yield = ([par value –price/price]* = (1000-x)/x *100 x = $909  In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

Bond Basics – Equation This relationship can be best summarized in the following equation: