Introducing debt (7)

What is Debt?

Debt is simply the obligation to repay something at a future point in time. It can take many forms including credit card debt, a mortgage on a property or a loan from the bank. Typically, debt comes with interest.

Bonds

When a Government or company wants to borrow money they issue debt in the form of bonds.

They do this because they want to raise money to fund projects – for a company this might be a new factory or R&D into a new product, for a government this might be to fund roads, schools and day to day spending.

This is debt packaged as a standardised financial instrument and it can be therefore be traded.  Bonds are purchased by investors and traders. The investor receives interest to compensate them for lending the bond issuer the money. A bond’s interest payment is called its coupon. This typically fixed when the bond is issued (created).

All bonds will state when they are due to be repaid, this is called the maturity date. Some can be short, like a year and sometimes a lot longer, like 50 years.

Because the coupon rate, coupon payment dates and the maturity date is known bonds are often referred to as fixed-income securities. This doesn’t mean the price is fixed, traders trade bonds in huge secondary markets. Factors like base rates, the creditworthiness of the issuer, the risk appetite of the market and the supply of alternative investment opportunities determine the bond’s price.

Because the price changes and the coupon stays fixed the yield on the bond changes. The current yield is calculated by the annual coupon payment divided by the current price.