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Bond (Finance)

A bond is a debt instrument used by companies, organisations or countries to raise debt capital. The bond issuer pays interest regularly (anually, semi-anually) in the form of a coupon on the principal to the bond holder until the bond reaches maturity. The discounted coupons and maturity directly affect the bond price taking into account the credit quality of the issuer. The price of the bond as well as the discounted cash flows thereby define the overall bond yield which is usually noted and compounded anually. The coupon rate which makes the price of the bond equal to its principal is called the par yield.

Duration

To hedge and organise bond portfolios a concept called duration is used, which measures the average date of the payments. The duration measures the sensitivity of the bond price to the interest rate (discount rate). Using duration and a convexity adjustment a market participant holding a bond portfolio can hedge his risk exposure. This process is called duration matching and is similar in its purpose to delta hedging in the case of equities.

Coupon

The coupon is the percentage that defines the annual or semi-annual payments of the bond.

Zero-coupon bonds

To determine a “natural” interest rate, it is necessary to look at bonds with zero coupons. However, these do not normally exist and are thus created “synthetically” by a financial institution. This institution “strips off” the coupon payments of a regular bond and then sells a security which it calls a zero-coupon bond.

Convertible bonds

A convertible bond is a bond that can be converted by its buyer to equity of the issuer. This happens with a conversion rate that determines the amount of shares that will be received. Converting may be favourable, if the company outperforms expectations. This hybrid form of bond allows for participation of potential increases of the share price while still maintening the security of a bond with fixed interest rate. That usually makes the convertible either more expensive or having a smaller coupon than a regular bond. For the issuing company/organisation convertibles are an interesting alternative when it wants to reduce its debt burden. When the bonds are converted, part of their debt “vanishes”.

Valuation of convertible bonds

A convertible is basically a bond with an attached option. This makes pricing with the Black-Scholes formula and usual bond pricing techniques quite trivial.

Reverse convertible bonds

Not to confuse with convertibles are reverse-convertibles which are often issued by banks as an attractive, low cost, high-yield financial product. In this case the issuer has the right to convert the bond to equity and will of course only do so if the share price decreases by a certain amount. This creates a high risk for the buyer of the bond, which is something that is often overlooked by retail investors.

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