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Definition of a Bond
A bond is a financial instrument for which the issuer, called also the borrower, agrees to pay certain amounts of money at specified dates in the future. These amounts of money are:
- interest, commonly known as coupons, (paid at specified regular intervals) and
- the par value of a bond, also called the principal value (paid at the bond’s maturity date).
In exchange for the obligation to pay coupons and the par value in the future, the issuer receives some amount of money today. This amount of money is called the price of a bond and the entity that pays this amount and purchases the bond is called the bondholder or creditor. The value of coupons and the price of the bond depend on the rate of return required by investors. And the rate of return required by investors largely depends on the risks associated with investing in the bond.
Quotation of Bonds
A bond is often quoted as:
- a percentage of its par value (e.g. 102.5%),
- a price per 1 USD of par value (e.g. USD 1.025),
- using fractions – the decimal value in the decimal fraction is represented as a vulgar fraction whose denominator is 2 raised to a certain power (e.g. USD 102 1/2).
Bonds Features to Know in Your Level 1 CFA Exam
5 basic features of debt instruments to remember in your Level 1 CFA Exam:
- principal value (par value),
- term to maturity (tenor),
- coupons and their frequency,
- type of issuer, and
- currency denomination.
Term to Maturity of a Bond
Principal value is the value which should be repaid at the bond’s maturity date. It is also the value used to calculate coupons when we know the coupon rate (given in %).
Bond Principal Value
Term to maturity, sometimes also called the tenor, is the number of years to the maturity date. At the maturity date, the issuer should fulfill all his remaining obligations towards bondholders. In the case of a common coupon bond, it means that the issuer should repay the principal and the last coupon at the maturity date.
Generally, if we take under consideration the time to maturity, we can classify bonds as:
- short-term bonds with a term to maturity of 1 to 5 years,
- medium-term bonds with a term to maturity of over 5 to 12 years, and
- long-term bonds with a term to maturity of over 12 years.
Coupons – Frequency, Bond types, Accrued interest
Coupons are the interest paid by the issuer at some strictly specified points in time. Typically, coupon payments are made semi-annually. However, we may encounter a situation in which coupons will be paid annually or quarterly or even monthly.
Taking coupons under consideration, we distinguish 3 basic types of bonds:
- conventional bonds, also called plain vanilla bonds, which pay fixed coupons,
- floaters, also called floating-rate notes (FRN), for which coupon changes from period to period, and
- zero-coupon bonds, also called pure discount bonds, which pay no coupons.
Question 1: Frequency of Bond Coupon Payments
If the coupon rate is equal to 6% and the par value amounts to USD 1,000, then on the assumption that coupons are paid semi-annually the single coupon payment will be equal to:
- USD 15.
- USD 30.
- USD 60.
Because the coupon is paid semi-annually and the coupon rate is always given annually, then the single semiannual payment is equal to 6% x 0.5 x USD 1,000 = USD 30.
Question 2: Coupon of a Floater
Let’s assume that the coupon is paid annually and is defined as LIBOR plus 3%. The par value amounts to USD 100. If at the beginning of the year LIBOR equals 2.2% and at the end of the year it is equal to 2.4%, then the coupon payment at the end of the year will be closest to:
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Accrued interest is important if a bond is purchased between interest periods. Accrued interest is the interest earned but not yet paid.
When buying a bond between interest periods, the counterparty will usually quote the so-called clean price. Clean price is the price of a bond without accrued interest.
Full price, which is also called dirty price, is the price that is actually paid for the bond. Therefore, the full price is equal to the clean price plus accrued interest.
Type of Issuer
Another bond feature is the type of issuer. We distinguish the following types of issuers:
- supranational organizations,
- national governments,
- local governments,
- quasi-government entities, and
Currency Denomination of Bonds
Of course, a bond can pay its coupons and the par value in any currency, but the majority of bonds throughout the world are denominated in US dollars or euros. There are also bonds that we call dual-currency bonds, which pay their coupons in one currency and the par value in another.
Level 1 CFA Exam Takeaways for Bond Features
- A bond is a financial instrument for which the issuer, in exchange for some amount of money received today, agrees to pay coupons and the par value at specified dates in the future to the bondholder.
- A bond is often quoted as a percentage of its par value, a price per 1 USD of par value or using fractions.
- 5 basic features of debt instruments to remember in your Level 1 CFA Exam: principal value (par value), term to maturity (tenor), coupons and their frequency, type of issuer, and currency denomination.
- Accrued interest is the interest earned but not yet paid and the full price is equal to the clean price plus accrued interest.