I'm looking for a very simplistic (ELI5) explanation of how bonds work, but I'm not sure I have the basics correct.
As I understand it, a bond is basically a IOU or loan. Any company, government or municipality can ask for a loan. This loan comes with a promise to pay back the full amount after an agreed set amount of time. In addition to full repayment of the loan, the lender will also receive some interest based on a percentage of the loan.
For example, a 2-year $100 loan with a 5% interest rate will pay $5 at the end of the first year, another $5 at the end of the second year as well as repayment of the original $100. At this point the loan is done.
The interest amount can be set at any percentage but companies tend to match government rates to stay competitive. However, once the interest rate is agreed upon it stays fixed for the length of the loan.
Traditionally, this loan agreement (or bond between parties) was written down on a fancy piece of paper (similar to everyday money) showing the initial amount of the loan. The interest payments were represented as detachable portions of this paper (similar to everyday shopping coupons). Thus they were referred to as coupon interest rates or simply coupon payments.
Similar to everyday paper money, the bond can be transferred or sold to a third-party for any agreed amount. However, unlike everyday money, determining a fair value amount is not as straightforward. The fixed coupon rate complicates the true value of the bond.
Using the above example of the 2-year bond, the government might change its general interest rate at any time during the 2 years. If government rates have fallen, the value of our bond has effectively increased because our bond has fixed rate of 5%. This higher rate can't be found anywhere else at the moment and thus we could sell this bond at a slight premium. If, on the other hand, government rates rise, the value of our bond has effectively decreased because the third-party could find a better return elsewhere and would only buy our bond if the cost were lower.
Since the face value (full repayment amount) and coupon rate are fixed and the effective bond value is flexible, the effective return or yield can also change.
- Is this basically a proper understanding?
- Does a bond's yield change only change after being sold to a third party at a premium or discount?