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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.

My questions:

  1. Is this basically a proper understanding?
  2. Does a bond's yield change only change after being sold to a third party at a premium or discount?
6

You're pretty much correct. But in question 2, a bond's yield is calculated based on its current market value. The price at which that particular bond last changed hands is irrelevant. If a particular bond issue is not widely enough traded to have a market value, then its yield becomes hard to calculate.

  • I like that you mentioned the bond liquidity. When making the calculation, it's important to doublecheck the underlying factors. Sometimes your data provider will show you a market value and a yield but it might be based on very old data, so it's pretty much useless. – vic Nov 7 '15 at 23:57
  • So does this mean as a owner of a particular bond, the yield as well as value, are both constantly changing? Doesn't this only matter when transferring or selling? Similar to how a stock could go up or down, it only really matters (i.e. locks in the gain or loss) when I sell it. – skube Nov 9 '15 at 17:25
  • Yes, the yield is constantly changing, generally speaking exactly opposite to how the value changes, since the return is fixed. When it matters depends on how you look at these things. Just because you haven't crystallised a loss by actually selling an asset whose value has decreased, that doesn't mean that you haven't suffered the loss. – Mike Scott Nov 9 '15 at 17:40
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  1. Yes as a very basic understanding that doesn't factor in callable options, convertible bonds to other securities, inflation-indexed bonds, zero coupon and savings bonds that would be other categories that exist.

  2. No, there is the question of when do you value a bond. For example, if you buy a long-term bond for $10,000 and half way to maturity it is worth only $5,000 how do you compute your yield: The price you paid, the price it is worth now or something else?

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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.

As an addendum to the other answers, this isn't entirely accurate. The face value of the bond is the principal that the issuer agrees to pay off at the end of the bond term; there is no need for it to exactly match the purchase price of the bond (i.e., the initial amount loaned).

An easy way to see this is to think about zero-coupon bonds (i.e., bonds without interim payments). All of the return to the lender would be the difference between the face value and the presumably-lower purchase price.

Returning to coupon bonds, the purchase price could be higher or lower than the face value; higher indicates that the coupon rate exceeds the market-demanded interest rate, and lower indicates the opposite. Purchase price matching face value only occurs when the coupon rate and market interest rate exactly match.

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