Trading and Valuing Bonds

The interest rate is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer.

These factors are likely to change over time, so the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par at the moment before they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of £100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. T-Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.

The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).
The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is sometimes known as the Clean price.
Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.

Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets also differ from stock markets in that investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

Bond

In finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity) longer than ten years. U.S Treasury securities issued debt with life of ten years or more is a bond. New debt between one year and ten years is a note, and new debt less than a year-bill

Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity, a bond with no maturity.

Traditionally, the U.S. Treasury uses the word bond only for their issues with a maturity longer than ten years, and calls issues between one and ten year notes. Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Market participants normally use bonds for large issues offered to a wide public, and notes rather for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities with three years or less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations have less risk, and are associated with shorter term obligations.

A bond is simply a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Debt securities with a maturity shorter than one year are typically bills. Certificates of deposit (CDs) or commercial paper are considered money market instruments.