Section 3.1 — The Basics of Debt

  • 🔹 Overview

    • Debt is another way for companies or governments to raise capital. Instead of selling ownership (like stocks), they borrow money from investors through debt securities such as:

      • Bonds

      • Notes

      • Bills

      • Certificates

      • Other money market instruments

      The issuer owes the investor both interest and principal.
      Debt securities are actively traded in the secondary market

2. Maturity:

  • The date the bondholder receives back the principal.

  • Common maturities: 5–30 years (but can be shorter).

  1. Types of maturities:

    • Term Bond: Entire principal repaid at once at maturity.

      • Often includes a sinking fund (cash reserve) to ensure repayment.

    • Serial Bond: Portions of principal repaid at intervals over time.

    • Balloon Bond: Combination — some repaid early, large portion at final maturity.

    • Savings Bonds: Federal government-issued;

      • Can be purchased/redeemed at banks or the U.S. Treasury.

      • Not traded in the secondary market.

      • Exempt from several securities laws.

1. Par Value (Face Value):

  • Usually $1,000 per bond.

  • Represents the principal repaid to the investor at maturity.

  • Bonds can trade at:

    • Par ($1,000)

    • Premium (above $1,000, e.g. $1,200)

    • Discount (below $1,000, e.g. $800)

  1. Bond pricing in points:

    • Each point = 1% of face value = $10
      → Bond trading at 90 = $900
      → Bond trading at 103 = $1,030

💰 Key Characteristics of Bonds

3. Coupon Rate (Stated or Nominal Yield):

  • The interest rate the issuer pays to the investor.

  • Fixed percentage of par value.

    • Example: 6% coupon on $1,000 bond = $60 interest/year

    • Usually paid semiannually ($30 every six months).

  1. Accrued Interest:

    • When a bond is sold between interest payments:

      • Buyer pays the seller for the interest accrued to date.

      • The issuer pays the next full coupon to the new owner.

      • Each investor effectively earns interest for the time they held the bond.

    • Zero-coupon bonds: No periodic interest → no accrued interest payments.

4. Bond Pricing and Interest Rates:

  • Bond prices are inversely related to market interest rates:

    • If rates rise, bond prices fall.

    • If rates fall, bond prices rise.

  1. Example:

    • Market rate = 6%

      • Bond paying 8% → more attractive → price rises.

      • Bond paying 4% → less attractive → price falls.

Bonds

〰️

Bonds 〰️

⚖️ Summary Table

Term / Definition / Key Points

  • Par Value / Principal repaid at maturity / Usually $1,000

  • Coupon Rate / Fixed interest rate / Paid semiannually

  • Term Bond / All principal repaid at once / May use sinking fund

  • Serial Bond / Principal repaid over time / Multiple maturity dates

  • Balloon Bond / Mix of serial & term / Large final payment

  • Savings Bond / Federal issue / Not traded; exempt from many laws

  • Bond Price / Quoted in points / 1 point = $10

  • Interest Rates vs Prices / Inverse relationship / Rates ↑ → Prices ↓

Next Section

✺ Review questions ✺

  • a) $100  b) $500  ✅ c) $1,000  d) $10,000

  • $950

  • Term bond

  • A cash reserve set aside by the issuer to retire bonds at maturity.

  • They fall.

  • Semiannually

  • No, they can only be redeemed with the U.S. Treasury or banks.