A bond is an I.O.U, a formal acknowledgement about a loan and its regular payments between the lender and borrower. Bonds are a type of security known as debt securities and are sometimes called ‘fixed-income securities’. They’re considered a low risk investment.
Governments and businesses will sell bonds, or borrow money in other words, to fund their expenses. For instance, the government might sell bonds to the private sector to fund public infrastructure development, schools, military equipment, etc. A business might sell bonds to hire people and buy capital goods such as computers.
There are also investment bonds which let you invest in managed share funds. They let you avoid capital gains tax after 10 years when you sell.
Bond Value
In general, the gross return on investment for an asset is generally expressed as: , where is the current price, is the previous price, and is the income (dividend) in the form of regular payments for holding the asset.
A bond has the following properties which dictate its value:
- Principal — the amount of money given.
- Term — time by which the principal must be repaid, ie. the deadline.
- Coupon payment — regular payment to the lender.
- Coupon rate — the interest rate on the bond.
Bonds can be traded on the bond market.
Remember, 100 in the future in almost all situations. The simple reason for this is because we can earn interest on the 100 by putting it in a savings account, for example. The value of a bond needs to take this into account by discounting the future value of payments: $$\colorbox{#FFFFBF}{V_t=\frac{\text{coupon payment}{1}}{1+i}+\frac{\text{coupon payment}{2}}{(1+i)^2}+\ldots \text{further rounds of payments.}+\frac{P+\text{coupon payment}_{n}}{(1+i)^n}$}$$ Bond price and the market interest rate are inversely related. Rises in the market interest rate decrease the value of a bond.