How Bonds Work

Cash Flow Structure of a Bond.|300

  • Lender lends money to the government (usually US Treasury)
  • Coupon payments pay regularly:
    • Semi-annually for US Treasury
    • Annually for other countries
  • Principal (=par, base) amount is paid at the maturity;
  • Time To Maturity (TTM) is time from now to when the principal pays
  • Yield
    • Current Yield
    • Yield to Maturity: Expectation Hypothesis defines yield to maturity as the expected rate of return if held til maturity.

Cash Flow Structure of a Bond

Governments are the borrowers of money in this transaction.

  • Government “issues” bonds regularly, which is
    • Primary Market: Treasury sells bonds (millions of $ worth) mostly to private Investment Banks
    • Secondary Market: Investment banks sell smaller chunks to private investors / bond holders sell to each otherUntitled|340
  • Governments pay coupon and principal through
    1. Tax revenue
    2. Issuing more bondsUntitled|380

Bonds are an important part of a portfolio because…

  • Are near-riskless investments as they generate stable cash flows. The only risks are: inflation risk—when the government doesn’t have the money, they’ll just print more money. This causes inflation which devalues the bonds.
  • Are very liquid, since many people are willing to buy bonds in most scenarios, even in recessions.