The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options. Bond market used to be rather simple, but as the number of new products grows, even a bond expert is challenged to keep pace with the innovations. Here we will explain the fundamentals of the bond market that are necessary to understand other aspects.
Fixed income security can be defined as a financial obligation of an entity that promises to pay a specified sum of money on specified dates in the future.
The word "fixed" in definition can be misleading, because many fixed income securities do not carry an obligation to pay a FIXED amount of money. Historically it was the case, but later various kinds of floating-rate instruments appeared, where the payments were not fixed. However, payments on floating-rate bonds are still determined using different formula. For example, LIBOR rate is the common benchmark for floating rate securities, so they carry an obligation of payments based on LOBOR rate, thus the payments are FIXED.
Expression "Fixed income securities" is often used as a synonym to "Debt securities". It is not entirely correct, as "Fixed income securities" universe comprises debt securities and preferred stock. Preferred stocks are a kind of hybrid between debt and equity, but as nowadays they are quite rare, "Fixed income securities" and "Debt securities" usually mean the same.
The term "BONDS" is also often used interchangeably with "Fixed income securities". There are different conventions on different markets regarding the use of terms "Bond", "Note" (short and medium term bonds) and "Bills" (short-term fixed income securities), but usually "BOND" is considered a synonym for "Fixed income security" unless otherwise specified.
It is important to stress that in the above definition "SECURITY" is an essential part of the notion. Securities are financial instruments that can be traded with low transaction costs. For example, it is quite costly to buy or sell bank loans, and in that way bonds differ from bank loans, as bonds are SECURITIES and bank loans are not.
There are 3 most important characteristics of bonds. Par value is the first one. The par value of a bond is the amount that the issuer agrees to repay the bondholder by the maturity date. This amount is also referred to as face value or principal.
In different countries there are different conventions regarding par value. For example, in U.S.A par value is usually set at $1,000. However, there are bonds with smaller par value (e.g. $25 or $1000). These bonds are called "baby bonds". To make it easier to compare bond prices for securities with different par value, the usual practice is to quote bond prices in percentage of par value. It is customary to say that the bond is traded at 105%, but quite uncommon to say it is traded at $1050.
The second important characteristic of the bond is maturity. The term to maturity is a period of time over which the issuer has promised to redeem the bonds. The maturity date is the date of redemption. The practice in the bond market is to refer to the "term to maturity" of a bond as simply "maturity".
The third most important bond characteristic is coupon, or the amount of money the bondholder receives. As bonds are usually quoted in percentage of par value, market professionals usually refer to coupon not as an amount of money, but as the coupon rate. The coupon rate is the interest rate that the issuer agrees to pay to bondholder. The amount of coupon payment is determined by multiplying the coupon rate by the par value of the bond. For example, if par value is $1,000 and coupon is 6% p.a., annual payment would be 6%*1,000=$60.
In the United States and some other countries the usual practice is to pay the coupon in two semiannual installments. However, in some European markets annual payments are more common. Some types of bonds, for example, mortgage-backed and asset-backed securities typically have monthly coupon.
