Simply put, a bond is an IOU issued by an institution in order to raise money. When individuals purchase bonds, they are loaning the bond issuer a specified amount of money with the expectation that they will be paid back the amount of the loan plus interest. Because of this, you might think bonds carry no risk, but this is not the case. Aside from the risk of the bond issuer not being able to pay back the loan, changes in the interest rate environment play a critical role in calculating the risk associated with owning a particular bond.
A basic bond is issued with a face value, coupon and maturity. Face value is the initial offering price of a bond and the amount a bond buyer will be paid back when the bond matures.Coupon is the amount the bond issuer promises to pay the bond buyer at predetermined intervals -- usually annually or semiannually.Maturity is the amount of time between the bond’s original issuance and when the issuer has agreed to pay back the full face value of the bond. A company might issue a bond with a face value of $100, a coupon of $10 and a maturity of 10 years. Here, the business is attempting to entice investors to loan them $100 by promising to pay them $10 every year for ten years. At the time of the bond’s maturity, ten years later, the issuer will pay the entire face value of $100 back to the buyer.
Yield and Price
A bond owner who does not want to hold a bond to maturity can sell it to someone else. While a bond is issued at a fixed price, its price can fluctuate dramatically once it begins changing hands in the open market. This is because the coupon remains fixed throughout the life of the bond, and buyers compare that with the coupon they could get on newly issued bonds. The bond's coupon divided by its current market price is called the "yield" and is expressed as a percentage. If a particular bond has a current price of $100, a coupon of $10 and maturity of 10 years, then it has a coupon yield of 10 percent, or $10 divided by $100. This is why a bond's price and current yield are said to have an inverse relationship. If the price of a bond rises, its coupon as a percentage of its price falls, causing its current yield to fall. On the other hand, if the price of a bond falls, its coupon as a percentage of its price increases, causing its current yield to increase. These possible fluctuations in price and yield are at the root of bond risk and duration.
Risk and Duration
Mathematically, a bond’s duration value is the percentage by which the bond’s price will change based on a 1 percent move in interest rates. So a bond’s duration is a measure of how sensitive a bond’s price is to fluctuating rates. The higher the duration value attached to a bond, the more price sensitive it will be to changes in interest rates. The lower the duration value attached to a bond, the less price sensitive it will be to changes in interest rates. Higher duration, therefore, means greater risk, while lower duration means lesser risk. So, if a $100 bond with a coupon rate of $10 and a maturity of 10 years has a duration value of 10, that means its price will change by 10 percent for every 1 percent move in interest rates. Again, yield is inverse to price. If interest rates increase by 1 percent, the value of the bond reduces by 10 percent, or to $90. If rates decrease by 1 percent, the bond's value increases by 10 percent to $110.
Putting it all together
When considering the purchase of a bond, a savvy investor will look at both the duration of the bond as well as the current interest rate environment. If she thinks interest rates may fall in the near future -- making her bond higher paying bond more valuable -- she may consider purchasing bonds with higher duration, as they will achieve greater price gains than bonds with lower duration. If, on the other hand, an investor foresees future interest rate increases -- making her bond less valuable -- she may consider buying bonds with lower duration, as they will be less sensitive to downward price pressure.
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