Face Value Of A Bond Finance Essay - Free Essay Example

Face value of a bond is the amount which is repaid by the issue to the investor at the time of maturity. Bond face value generally represents the redemption value of the bond. The interest on bonds is also calculated on face value. However, the actual value of bond depends upon the interest rates and volatility prevails in the market, bond would sell at a discount if the present interest rates are higher than the coupon rate of bond and would sell at premium if present interest rates are lower than the coupon rate but as bonds approach maturity, actual value approaches face value. Generally, corporate bonds are issued with the face value of $1000, municipal bonds carry the face value of $5000, and government bonds usually carry the face value of $10,000. For example- if a company wants to raise $1,000,000 through bonds in capital market and each bond carried a face value of $1,000 each then, the company would have to issue 1,000 bonds in the market to meet the set target of $1,000,000. Zero coupon bonds are those bonds which do not pay any payment in terms of interest during the whole life of bond and these bonds are sold at a deep discount from its face value or we can say that investor bought these b onds at a price below than the face value. The main idea behind the issuance of zero-coupon bond is to provide an option to investor to purchase bond at a lower price than its face value and decrease rate upfront in return for paying this, a rate of interest is offered to the bond holder that will ultimately yield a return which is equal to the face value of that bond or possibly little more than that. These bonds do not carry any coupon rates because these bond does not make any periodic interest payment and on maturity investor receive a lump sum amount equals to that bonds par valve. The date of maturity on these bonds is generally long-term in nature and these bonds are not redeemable until they reached the maturity date. So these types of bonds are very fruitful to those investors who have certain goal and plans for future. Due to no interest is paid on zero coupon bonds until maturity, prices of these bonds fluctuate more than other types of bonds which are available in the market. Although there are no payments of interest made on zero coupon bonds till their maturity, certain tax might have to be pay by the investor. Example of zero coupon bonds is U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds etc. MUNICIPAL BOND Municipal bonds are those bonds which are issued by the civic authority of a city. The basic idea behind these bonds is to raise fund for the development of infrastructure in the city or ongoing government expenditures. Tax benefit may or may not be available on these bonds because interest received from such types of bonds are full exempted from all types of tax if the person lives in that city or state in which these bonds issued but the capital gain on these bonds are taxable. These bonds may be issued to retail investors or institutional investors. The coupon rate is relatively low as these bonds have a guarantee provided by the government and due to the tax saving by purchasing of these kinds of bonds. The risk of a municipal bond is depends upon that how the payment will be made by the issuer of these bonds, because different types of bonds have different type of repayment process such as if the bonds are General obligation bonds then repayment would be based on the ful l faith and credit of the issuer; and consider to be the most safer bonds in this type of bonds and as a result fetch low interest rates. If the bonds are Revenue bonds then repayment would be based on the future income of the issuer and therefore carry high rate of interest as comparison to general obligation bonds. JUNK BOND Junk bonds are generally speculative in nature and come under high risk and high yield bonds class. The coupon rate of interest is high on these bonds as comparison to other type of bonds. However, the interest risk and principle risk of these bonds are also higher. In principle, these bonds have a very low or no credit rating. Only speculators may likely to trade in junk bonds and investors generally do not favor these bonds. DEBENTURES Debentures are fixed income security which is issued by a borrowing unit under a borrowing agreement. Under the agreement, the issuer has to pay periodic interest payments to the holder on specific dates. The rate of interest called the coupon rate which is a fixed and is applied to the face value of debenture to find out the periodic interest payment. At maturity issuer repays the debt. The repayment amount is made as per the terms and conditions of the agreement and may be equal to, less than, Or more than the face value of the debenture. These are issued keeping in view the need and cash flow of the company as well as investor. Bonds have not the same attraction as stocks in the mind of investors, but fixed and promise return makes bonds be an essential part of your financial plan. There are certain advantages for a buyer of a bond which is as follows: Fixed Income Coupon rate of interest on Bonds pay a fixed or predetermine payment every year to the buyer of a bond until the Bond reaches up to its maturity date. For example- A Bond carries the coupon rate of 10 %, in this condition you will receive $10 per bond every year, for a bond with the face value of $100. Volatility Bonds volatility is lower than that of equities. As a result bonds are normally considered as safer investments than equities. In addition, day- to-day volatility in bonds is also less as comparison to stocks, and sometimes payments of interest of bonds are also higher than the dividend payments on stocks. Good Collateral for Loans Bonds are considered to be good collateral for loans. If any investor needs to borrow money and he doesnt want to sell his bonds then in this case brokerage firm and banks will consider your bonds as collateral for a loan and interest charges on the borrowed amount can be repaid from the interest income from the bonds. Time period Bonds are issued for a certain and fixed period of time i.e. 5 years, 10 years etc, investors can buy bonds according to their investment period horizon. If an investor needs money after 10 years then he can easily invest in long term bonds and after 10 years he will get the money back. Return of Principal at Maturity If you hold the bond till maturity than the bond price will not affected by the market condition weather the price of that bond is high or low you will get the same predetermined principal amount. But if you sell the bond before maturity then you will get the prevailing market price of that bond so by buying the bonds, investors have an advantage to earn capital gain. Credit Ratings Each and every Bond carries credit ratings from various credit rating agencies which show the nature of bonds that how much that particular bond is risky so the investor knows that which risk class bond he is buying and how much volatile is that bond. Tax Advantages Some bonds give tax advantage to investors. The interest payments on certain bonds are tax free while calculating the income of the investor. YTM Yield to Maturity (YTM) can be define as the annual rate of return that will be earned if the bond is purchased today at the current market price and is held by the investor till maturity. So, YTM is the average rate of return that will be earned on a bond if it is bought now and held till maturity. It shows an effective annual return from a security expressed as a percentage of the current market price of the security. It is a measure of total income earned by an investor over the total life of security. YTM is also known as market rate of return on market rate of interest. So, YTM is the rate of return that will be earned by the investor under the following conditions: Bond is purchased today at current market price Issuing company does not do any default on payment of interest. Investor holds the bond till maturity. Whatever the interest received for the intervening periods are reinvested at the rate equals to calculated YTM itself. YTM is calculated as the rate of discount that makes the present value of a bonds cash flow equals to its current market price. LADDERING A bond ladder is a type of strategy in which an investor managing his fixed-income by converting his money in to bonds with different maturity period i.e. one month, three month, six month, one year etc. For example, if you invest $1,000,000 for ten year by purchasing bonds in such a way that one bond mature each year. Now if we see after one year when the first bond matures, the principal amount of that bond is reinvested in another bond at the long end of the ladder and this process goes till the 10th year. The primary idea behind this strategy is diversification by maturity. By making the bond ladder an investor fetch high average return because as we all know that longer the maturity period, the higher the risk and as a result the higher the yield and bond ladder combines the longer a bonds maturity with the liquidity of short term bonds to generate high average return. Whenever you think of creating a portfolio of bonds with different maturity class different risk and return, at that time you have to be much strategized for selecting a particular bond so that you can generate maximum return with low risk. If you are able to make that strategy you as an investor can earn steady and reliable income. There are certain strategies which are prevailing in market by using them investors fixed their returns. Some strategies are Laddering, Maturity matching, Barbell etc. Laddering A bond ladder is a type of strategy in which an investor managing his fixed-income by converting his money in to bonds with different maturity period i.e. one month, three month, six month, one year etc. For example, if you invest $1,000,000 for ten year by purchasing bonds in such a way that one bond mature each year. Now if we see after one year when the first bond matures, the principal amount of that bond is reinvested in another bond at the long end of the ladder and this process goes till the 10th year. The primary idea behind this strategy is diversification by maturity. By making the bond ladder an investor fetch high average return because as we all know that longer the maturity period, the higher the risk and as a result the higher the yield and bond ladder combines the longer a bonds maturity with the liquidity of short term bonds to generate high average return. Maturity matching This strategy is also called Bullet strategy, in this type of strategy investor buy or holds those bonds whose have same maturity period or we can say that bonds mature at same time. It is not necessary that you buy all the bonds at same time, in bullet strategy bonds maturity time is same but not the purchasing date. This strategy considers being an effective approach to minimize your interest rate risk by confounding your purchase date because interest rates are changed time to time. Investors also follow this strategy at that time when they need money at a specific time and for a specific purpose. Barbell When you go for the barbell strategy, you purchase long-term and short-term bonds only without purchasing anything in between these limits. By purchasing long-term bonds you would fetch higher interest rates, while purchasing short-term bonds, they provides flexibility to your portfolio to invest in other assets should rates fall too low to provide sufficient income. If in future rates go up, you can hold the short-term bonds till their maturity and then after reinvested them at the higher prevailing interest rates. So, by adopting this strategy you would take advantage of fluctuating rates without restricting your financial flexibility. Whenever you want to purchase bonds or want to invent in bonds, first of all you have the knowledge of all terminologies related to bonds such as what is yield, where to find out the price of a particular bond, what is the maturity period, what is the face value etc. This knowledge will help you to make an attractive portfolio which fetch hig h return which is the ultimate aim of any investor. You can find information regarding the price of the bond at www.investingbond.com or you can find out this information from the reports which are issued in The Wall Street Journal which contain all the relevant detail about the corporate and other types of bonds through which investors select bonds according to their needs. The report contains various columns such as: Issuer This is the company name which is the issuer of the bond Coupon- it shows the fixed interest rate that the issuer of bond pays to the investor or the buyer of bond. Maturity Date- This is the date on which bond will mature and issuer will repay the principal amount to investor. Bid Price- This is the price at which bond is traded in the market or we can say that someone is willing to pay for the bond. Whatever the par value is, the bid price is quoted in relation to 100 i.e. percentage terms. Yield- Yield shows the annual return if the inv estor holds the bond till maturity. Preferred stocks are those stocks which provide a fixed dividend to the preferred shareholder. Dividend must be paid to preferred share holder before the payment to be made to holders of common shares. When we compare these stocks with bonds and common stocks in terms of making payouts then these stocks rank lower than bonds and higher than common stocks. Main advantages of preferred stocks are as follows: Preferred stockholders receive dividend first in comparison to common stockholder in the event of winding up, bankruptcy of a company. Holder of preferred stockholders have greater claim right on the assets of the company than the common stock holders. Some preferred stocks can be convertible into common stocks after a certain period of time. The main benefit of this convertibility is that the preferred shareholder gets the voting right after covert it into common stock. Dividend in preferred stocks is cumulative in nature. The se stocks can be callable at any time according to the needs of the company which issue the preferred stocks. Equal participation is to be done by the common shareholders if the earnings made through additional issuance of ordinary shares. But, in case of preferred stock, there is no such participation is to be done by preferred shareholders. Their claims per share are restricted up to a limited amount. Alike as bonds, various major credit-rating companies and agencies also provide ratings of credit risk for Preferred stocks to safeguard the interest of the shareholders. Preferred stocks rating is generally lower than the bonds, because dividends on preferred stock do not carry the similar guarantees as interest payments from bonds that is why preferred stocks are always lies below the bonds and are junior to every creditor. There are certain major credit agencies such as Standard Poors and Moodys provide ratings to preferred stocks on a regular basis. Bonds can be classif ied on the basis of various categories such as their characteristics, their risk class, their return, their credit rating, their coupon arrangements etc. the main three classifications of bonds are as follows: CLASSIFICATION ON THE BASIS OF CHARACTERISTICS Secured and unsecured Bonds- Whenever a long term source of funds is issues it is issued as a secured debenture and having fixed or floating charges on the assets of the company. The security helps reducing the risk of debt investors. Mortgage backed bonds are the example of secured bonds which are backed by the homes and other real estate properties. On the other side, the unsecured bonds are those bonds which are secured by the general liability of the company but do not carry any particular assets or specific charge as security. CLASSIFICATION ON THE BASIS OF COUPON ARRANGEMENTS Interest calculation is also a criterion for the classification of bonds because interest calculation of bonds is different from each other it is not necessary that each bond has same type of interest calculation. Certain bonds have a provision of regular interest payment till maturity and certain bonds do not carry any interest rate i.e. zero coupon bonds. Zero Coupon Bond-Zero coupon bonds are those bonds which do not pay any payment in terms of interest during the whole life of bond and these bonds are sold at a deep discount from its face value or we can say that investor bought these bonds at a price below than the face value. The main idea behind the issuance of zero-coupon bond is to provide an option to investor to purchase bond at a lower price than its face value and decrease rate upfront in return for paying this, a rate of interest is offered to the bond holder that will ultimately yield a return which is equal to the face value of that bond or possibly little more t han that. These bonds do not carry any coupon rates because these bond does not make any periodic interest payment and on maturity investor receive a lump sum amount equals to the par value of that bond. The date of maturity on these bonds is generally long-term in nature and these bonds are not redeemable until they reached the maturity date. So these types of bonds are very fruitful to those investors who have certain goal and plans for future. Due to no interest is paid on zero coupon bonds until maturity, prices of these bonds fluctuate more than other types of bonds which are available in the market. Although there are no payments of interest made on zero coupon bonds till their maturity, certain tax might have to be pay by the investor. Example of zero coupon bonds is U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds etc. CLASSIFICATION ON THE BASIS OF RISK Certain bonds can be classified according to their risk class. There are various rating agencies such as Standard Poors and Moodys Duff Phelps who provide ratings to various municipal and corporate bonds on a regularly basis. Junk bonds are one of them. Junk Bond-Junk bonds are generally speculative in nature and come under high risk and high yield bonds class. The coupon rate of interest is high on these bonds as comparison to other type of bonds. However, the interest risk and principle risk of these bonds are also higher. In principle, these bonds have a very low or no credit rating. Only speculators may likely to trade in junk bonds and investors generally do not favor these bonds