What are bonds?

Bonds, as an investment option, generally carry lower risks and offer relatively stable dividend payments compared to stocks. For investors seeking long-term stable investments and aiming for "passive income," bonds may represent a sound choice.

Bonds are financial instruments typically issued by countries, governments, corporations, or other entities to raise funds for various projects or daily operations.

In simple terms, bond issuers borrow money from investors, promising to pay fixed interest before maturity and repay the full principal amount at maturity. To reassure investors, the issuer provides an "IOU," which is essentially the bond. An analogy from daily life:

Imagine a friend borrowing $1,000 from you and promising to repay you in five years.During those five years,they will pay you 50 in interest annually and provide an IOU, which is akin to you purchasing a five-year bond.

Once the basics of bonds are understood, it's crucial to comprehend their five key elements:

Face Value: aka par value. The face value is the amount the issuer returns to the investor at maturity. Regardless of whether you purchase above or below face value, you can only recover the face value amount upon maturity. For instance, a $100 face value bond,bought for $105 or $95, will still yield 100 at maturity.

Bond Price: The price at which a bond is purchased determines the ultimate earnings. For example, buying a $100 face value bond for $95 and receiving $100 atmaturity without interest yields a $5 profit (100 - 95 = 5).

Maturity Date: The date when the bond expires. Upon maturity, the issuer repays the debt at face value, though investors can sell bonds before maturity.

Coupon Rate: The coupon refers to the interest paid by the issuer to investors semi-annually or annually before maturity. The coupon rate is the coupon divided by the bond's face value, also known as the nominal interest rate. In essence, the coupon is the interest paid to investors at scheduled intervals. Typically, bond coupons are paid semi-annually in equal amounts. For example, on a $100 bond with a 5% coupon, the issuer would pay the investor $5 in interest annually, payable semiannually. This means that bondholders receive $2.50 in interest every six months.

Bond Yield to Maturity(YTM): This represents the return investors earn by holding the bond until maturity. Annualizing this calculation gives us the commonly referred to bond's annualized average yield.

Let's illustrate with an example: Suppose you buy a three-year, $100 face value, zero−coupon bond for $95. Your total and annualized yield to maturity would be:

Total Yield to Maturity: (100-95)/95 = 5.26%

The formula reveals that lower bond prices result in higher yields to maturity, indicating an inverse relationship between bond prices and yields to maturity.

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