Bonds - An Overview

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A bond is also known as debenture. A bond is a contractual financial instrument. Under this financial arrangement, a bond is bought by a consumer from an institution or firm. The issuer is obliged to pay to the customer, a given sum of money known as maturity value at a fixed date in the future known as maturity date.Moreover, interest is paid periodically at a fixed rate of interest known as the coupon rate.

Bonds are easy to value. This is because the principal amount and the maturity date is fixed at the time of inception of the contract. However, the bond price are determined by several factors. These factors include:

• Maturity value: As the bond approaches maturity, the price of the bond will sell at par value or the maturity value.
• Investors required rate of return:  When then coupon rate of interest is equal to the required rate of return, the bond will sell at par. When the coupon rate is more than the required rate of return the bond will sell at a premium and vice versa.
• Changes in the market interest rates: With an increase in interest rate, the price of the will decrease and vice versa.   In other words,there is an inverse relationship between  bond prices and interest rate changes.

There are many different types of interest rates that affect the pricing of bonds.

Treasury Rates: These are also known as risk free rates and refer to the rate of interest at which the government borrows its own currency. It is risk free because the government can always pay back the amount by printing more money. Therefore, the US dollar treasury rate is the rate at which the US government can borrow in US dollar and the Indian rupee treasury rate is the rate at which the Indian government can borrow in Indian rupees and so on.

LIBOR Rates: This is also known as London Inter bank Offer Rate. This rate specifies the rate at which a large international bank lends money to another large international bank. LIBOR rates often change because economic conditions keep changing.

Repo Rates: This is quoted when there is a repurchase agreement to fund trading activities. An owner sells securities to a third party and agrees to buy them at a higher rate. The difference it the rates is referred to as repo rate. Overnight repo rates negotiations are most common, where the agreement is renegotiated everyday. Longer term arrangements which are used at times are known as term repos.