The Foundation of Bonds

A bond is an financial asset of which you need to pay a certain amount of money now in exchange for a series of payments in the future. There are two types of payments, the payments with nominal value and coupon payments:
  • The payment of nominal value is printed on the face of the bond and is made effective on the date the bond matures.
  • Coupon payments are generally done two times a year until the expiry date of the bond. These are called coupon payments because before computerized registration existed, you literally had to cut a coupon of the certificate and send it by mail in order to receiver you payment.

Generally bonds have expiry dates of 1, 5, 10, or 20 years.

Bonds do not guarantee any return rate. All they do is promise to make the payments of the coupons and nominal value on time. The return rate depends on how much you pay for the right of receiving those payments.

If you think all we are talking about is gibberish, be patient with us. Imagine a type of really simple bond, a zero coupon bond. (It is called this way because you do not have to make any payments on the coupons). The only payment of this bond is the payment of the nominal value when it expires. To make things very simple, suppose that a bond pays the holder exactly $100 in exactly one year’s time.

If you have a bond, you will need to know that the return rate of the bond depends on how much you pay now for it. Suppose that you are na?ve to pay $100 right now for the bond. You return rate would be of zero percent because you paid $100 for something that will pay you $100 in one year.

On the other hand, supposed that you only pay $90 for the bond now. Your return rate would be of around eleven percent because ($100-$90) /$90 equals 0,111, or 11,1 percent. If you could buy a bond for only $50, your return rate would be of one hundred percent because your money would duplicate in one year.

This is a fact that you should memorize. The return rate over a bond varies inversely with what you pay for it. Given the fact that it is always a fixed amount, the more you pay now for the bond, the less is the return rate. When the prices of the bonds are higher, the return rates are lower.