Fixed Income Securities Basics – Structure

Happy New Year 2014 and Welcome to this blog. Hope you enjoy these posts and take away something from this.  Happy Journey.

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A fixed income instrument or a bond is a financial security that promises to pay a fixed income stream at fixed dates in the future.

Typically issued by governments, state agencies municipalities and corporations. When a corporation or government wants to borrow money, it often sells a bond to investors or lenders.
In structure a bond is the same as a loan.

Let us consider a basic bond. The borrower receives a principal amount from the investor for a fixed period of time.

The borrower promises the following to the investor:
1. Pay the regular interest or coupon payments every period till bond maturity. This rate of interest is fixed at the beginning and also called the coupon rate.

2. Repay the initial borrowed amount at maturity. Maturity is the end date of the borrowing period or term. The borrowed amount or principal is also called the face value of the bond (this would be the  amount shown on the bond certificate issued by the borrower to the investor or lender).
The bond structure can be represented by the below picture.



The above picture is a cash flow representation of the bond over its life. Such a representation makes it easier to understand a bond visually.

Key Points
1. On issue date, initial bond face value paid to issuer
2. On periodical intervals, regular interest or coupon payments are paid to the investor.
3. At maturity, bond face value is redeemed by issuer and paid to the investor

To summarize, a basic bond is characterized by the following:

• Maturity date
• Face, par or principal value
• Interest Rate (or Coupon Rate)
• Number of interest payments per year (typically 2; also called coupon payments)

Example of a Basic Coupon Bond
Bond Parameters:

1. Bond Face Value: $100,000
2. Bond Term: 5 years
3. Coupon Rate: 4%
4. Coupon Payment: Six Months (Semi-Annual)
5. Bond Issued on 15 March 2011 and will mature on 15 March 2016

Since the coupon rate is 4%, the annual interest will be
Annual Interest = 0.04 x 100,000 = 4000
Semi Annual Coupons will be half of 4000 = 2000

We will continue to look at more real life examples and understand more about the bond characteristics, issuance, risks and valuation.