7

An Introduction to Bonds and Bond Pricing

7.1 INTRODUCTION AND OBJECTIVES

In this chapter we give an overview of bonds which are fixed-income instruments. A bond is a debt instrument between two parties. One party (called the issuer, debtor or borrower) is the borrower of capital and pledges to pay interest and a redemption amount (the amount borrowed) to a lender (also known as the investor or bondholder). A plain vanilla (bullet) bond is a bond with a simple cash flow structure that provides coupon (or interest) payments at regular intervals (usually each half year) over the lifetime of the bond issue. The issuer repays the full redemption amount when the lending period expires (also known as the maturity or expiration date). Under the assumption that the issuer does not default or choose to redeem the issue prior to the maturity date then the investor is assured of a known cash flow pattern. A detailed description of the contract is contained in the bond indenture that defines the obligations of the issuer. Common features are:

  • The type of issuer: bonds can be issued by governments and their agencies, municipal governments as well as domestic and foreign corporations.
  • Maturity date: this is the date after which the bond ceases to exist. At this time the issuer redeems the bond by paying the principal.
  • Principal amount: this is the amount used to calculate the coupon of the bond. Synonyms for the principal are: par value, nominal value and face value.
  • Redemption value: the ...

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