A bond is a financial product which represents some debt. It is a debt security issued by an authorized issuer which can be a company, financial institution, or Government. The issuers offer returns on bonds to the lenders in the form of fixed payment of interest for the money borrowed from them.

A bond is having a fixed maturity period of its own. It is an obligation of the authorized issuer in paying interest and/or repaying the principal at a future date upon maturity. However, such payouts are dependent on the terms and conditions associated with the bonds issued by the said issuer.

A)

Impact of discount rate on bond valuation

All types of bonds pay interest to the bondholder. The amount of interest is known as the coupon rate. Unlike other financial products, the dollar amount (and not the percentage) is fixed over time. For example, a bond with a face value of $1,000 and a 2% coupon rate pays $20 to the bondholder until its maturity. Even if the bond price rises or falls in value, the interest payments will remain $20 for the lifetime of the bond until the maturity date.

When the prevailing market interest rate is higher than the coupon rate of the bond, the price of the bond is likely to fall because investors would be reluctant to purchase the bond at face value now, when they could get a better rate of return elsewhere. Conversely, if prevailing interest rates fall below the coupon rate the bond is paying, then the bond increases in value (and price) because it is paying a higher return on investment than an investor could make by purchasing the same type of bond now, when the coupon rate would be lower, reflecting the decline in interest rates.

B) Characteristics of bonds issued by corporations

Bonds have the following characteristics

Face value

Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.

Interest

Most bonds pay interest every 6 months, but it's possible for them to pay monthly, quarterly or annually.

Coupon or interest rate

Fixed-rate bonds generate a constant interest rate. You receive the same amount each year or month, depending on the interest payment schedule.

There are also 2 types of floating-rate bonds. The interest rate is either set in advance each year or tied to market rates.

Step-up bonds have yields that increase over a set period (e.g., 4% the first year, 4.5% the second year, etc,). They can also be bought back at the issuer's choosing.

Other bonds have an adjustable floating rate, tied to market rates such as Treasury bills. If Treasury bill yields to up, the investor wins out. The reverse also is true: if yields go down, the bond issuer wins

Maturity

Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued!

A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, the longer the time to maturity, the higher the interest rate. Also, a longer term bond will fluctuate more than a shorter term bond.

Issuers

The issuer's stability is your main assurance of getting paid back when the bond matures.

For example, the Canadian and U.S. governments are far more secure than any corporation. Their default risk–the chance of the debt not being paid back–is extremely small, so small that they are considered risk free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation.

A company on the other hand must continue to make profits, which is far from guaranteed. This means the corporations must offer a higher yield in order to entice investors–this is the risk/return trade-off in action.

Rating agencies

The bond rating system helps investors distinguish a company's or government's credit risk.

Blue-chip firms, which are safer investments, have a high rating while risky companies have a low rating.

The chart below illustrates the different bond rating scales from the major rating agencies: Moody's, Standard & Poor's ("S&P") and Dominion Bond Rating Service ("DBRS").