Characteristics of interest rate securities
An Interest Rate Security has 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 to be paid to an investor at the maturity date of a bond. Bonds can be issued at different face values, however, in Australia, bonds typically have a unit face value of $100.
A coupon refers to the interest rate paid to the holder of an Interest Rate Security. Coupons can be fixed, floating or payable at maturity. Most debt securities traditionally have a coupon that is fixed until maturity, is a percentage of the face (principal) amount, and pay interest semiannually. For example, a $10,000 Interest Rate Security with an 5% p.a. coupon will pay investors $500 a year, in payments of $250 every six months. When the Interest Rate Security matures, investors receive the full face amount of the security (in this example, $10,000).
Some issuers and investors prefer having a coupon that periodically
adjusts, and more closely tracks prevailing market rates. The coupon on
a floating-rate Interest Rate Security is reset periodically in line
with changes in a base interest-rate index, such as the rate on 90 day
Coupon payments are made at regular intervals throughout the life of the bond and are usually quarterly or semi-annually. Fixed rate bonds generally have semi-annual coupon payments while floating rate notes normally pay interest quarterly.
The Yield is the return an investor receives on a bond. The yield is based on the price paid by an investor for a bond and the payments (coupons) received if the bond is held to maturity. The most important types of yield are the nominal yield and the yield to maturity.
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 bond (except in the case of a floating rate note). Yield to maturity is the return an investor receives at a given price. It is the most useful indicator of the value of a bond because it enables comparisons to be made of the return between different types of Interest Rate Securities and interest rate based products.
The final coupon and the face value of a bond is repaid to the investor on its maturity date. The time to maturity can vary greatly, although in Australia it is typically between 2 and 20 years. Perpetual Securities are a type of bond with no maturity date. To redeem this type of investment, investors must sell the security 'on market'.
The purchase price (also known as the gross price) is the total amount that an investor pays for a bond. Purchase price comprises the number of bonds that an investor buys times the price paid for a bond.
The purchase price includes two components:
- Capital price which is the price of the bond as estimated by the market based on a number of variables including interest rates, maturity date, ranking and credit quality.
- Accrued interest on the bond which is the amount of interest accumulated on a bond since the last coupon payment. Because interest is paid at regular intervals the bond price increases daily by the amount of interest accruing. On a 6.50 per cent 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 prices quoted on ASX Interest Rate Security Market reflects a gross price. The price you pay for an Interest Rate Security is based on a variety of factors, such as prevailing market interest rates, credit quality, maturity terms and tax status. Newly issued interest rate securities normally sell at or close to their face value. Prices of interest rate securities traded in the secondary market, however, fluctuate in response to changing interest rates. When the price of a Interest Rate Security increases above its face value, it is said to be selling at a premium. When a Interest Rate Security sells below face value, it is said to be selling at a discount.
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