All bonds have the following characteristics:
An organisation which issues a bond is referred to as 'the issuer' or 'the borrower'. The most active issuers of bonds today are governments and government agencies (government bonds), banks and corporations (corporate bonds).
Face value is the amount that is payable to an investor at the maturity date of a bond. Bonds can be issued at different face values, however, in Australia, they typically have a unit face value of $100.
A coupon refers to the interest rate payable to the holder of a bond. Coupons can be fixed, floating or payable at maturity.
Bonds traditionally have a coupon rate that is fixed until maturity, is a percentage of the face (principal) amount, and typically pay interest semi-annually. For example, a $100 bond with a 5% p.a. coupon will pay investors $5 a year, in payments of $2.50 every six months. When the bond matures, investors receive the full face amount of the bond (in this example, $100) and the final coupon ($2.50).
Some issuers and investors prefer having a coupon that periodically adjusts, and more closely tracks prevailing market rates. The coupon on a floating-rate bond is reset periodically in line with changes in a base interest-rate index, such as the rate on 90 day Bank Bills. These types of securities are generally described as Floating Rate Notes or Floating Rate Bonds.
Coupon payments can be made annually, semi-annually or quarterly, or as otherwise provided in the terms of the bond. Fixed rate bonds generally have semi-annual coupon payments while floating rate notes normally pay interest quarterly.
Yield to maturity
Yield to maturity (YTM) is the return an investor receives on the bond. The yield is based on the price paid by an investor for the bond and the payments (coupons) received if the bond is held to maturity. It is the most useful indicator of the value of an interest rate security because it enables comparisons to be made of the return between different types of bonds.
Nominal yield or coupon rate
Nominal yield, also known as the coupon rate, is the cash flow investors receive from a bond and does not change throughout the life of the security (except in the case of floating rate notes).
The maturity date is the date that the final coupon and the face value of a bond is due to be repaid to the investor. The time to maturity of a bond can vary greatly, although in Australia it is typically between two and 20 years. Some bonds are perpetual with no maturity date. To redeem this type of investment, investors must sell the bond 'on market'.
The purchase price is the total amount that an investor pays for a bond. The purchase price comprises the number of bonds that an investor buys times the market price paid for one bond.
The market price or gross price, includes two components:
- Capital price which is the price of the security as estimated by the market based on a number of variables including interest rates, maturity date, ranking and credit quality.
- Accrued interest on the security which is the amount of interest accumulated since the last coupon payment. Because interest is payable at regular intervals the price increases daily by the amount of interest accruing. On a 6.50 % annual coupon, interest accrues at 1.78 cents per $100 per day. Immediately following the coupon payment the price should fall by the amount of that coupon payment.
The gross price of a bond is determined by adding any accrued interest to its capital price. The price quoted on ASX reflects a gross price. The price you pay for a bond is based on a variety of factors, such as prevailing market interest rates, credit quality, maturity terms and tax status. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.