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Consider how a bond works, and why bonds are issued. Review how an investor can profit from owning a bond. Go over present value.
A bond is a debt instrument. Entities issue bonds to raise money for a specific purpose. Governments issue bonds to raise capital for public projects, like a road or a bridge. Corporations issue bonds to raise money to expand their businesses. All of the features of a bond are stated in the bond indenture. Bonds are usually issued in multiples of a $1,000. Assume, for example, that IBM issues a $1,000,000 6% bond due in 10 years. The bond pays interest semi-annually. $1,000,000 is the face amount or principal amount of the bond. That is the amount that must be repaid by the issuer at maturity. IBM (the issuer) must repay the $1,000,000 to the investors at the end of 10 years. The bond matures in 10 years. The bond pays interest of ($1,000,000 multiplied by 6%), or $60,000 per year. Since the bond pays interest semiannually, the issuer must make two payments of $30,000 each. Using the same example, keep in mind that dozens of investors may buy a portion of the $1,000,000 bond issue. Each investor will be paid interest twice per year. An investor will also receive their original investment (principal or face amount) when the bond reaches the maturity date. Many retired people buy bonds because of the predictable stream of income from the interest payments. All bonds are rated, based on their ability to pay interest and repay principal on a timely basis. A bond with a higher rating is considered a safer investment due to the collateral securing the bond and/or the financial strength of the issuer. All things being equal, lower rated bonds generally pay a higher rate of interest since they have greater risk of default. Assume that IBM and Acme Corporation both issue a bond due in 10 years. IBM has a high credit rating and offers a 6% interest rate. If Acme has a lower rating, the company will have to offer a rate higher than 6% to attract investors. To compute the value of a bond at any point in time, you add the present value of the interest payments plus the present value of the principal you receive at maturity. Present value adjusts the value of a future payment into today's dollars. Say, for example, that you expect to receive $100 in 5 years. To find out what the $100 payment is worth today, you would compute the present value of $100. The dollar amount is discounted by a rate of return over the period. This rate of return is often called the discount rate. An investor can select the discount rate using several different approaches. The discount rate may be your estimate of the rate of inflation over the remaining life of the bond. Your discount rate may also be a minimum expected rate of return. The minimum expectation is based on the bond's credit rating, and the interest rate paid by bonds of similar quality. Assume that you decide on a 4% discount rate for the $100 payment due in 5 years. The discount rate is used to discount (reduce) the value of your future payments into today's dollars. In this case, you're calculating the present value of a single sum of money. You can find present value tables on the Internet, or simply use an online present value calculator. If you use a table, you will locate the present value factor for a 4% discount rate for 5 years. That factor is .822. The present value of $100 is ($100 X .822 = $82.20). The present value of your bond is (present value of all interest payments) + (present value of principal repayment at maturity).