Financial Instruments and Markets: A Casebook

2

Note on Bond Valuation and Returns

All securities can be evaluated based on certain common characteristics: value, rate of return, risk, maturity, and so on. In this note, we look at how bonds are valued in general and how their rates of return are computed. Beginning with basic definitions and features of fixed income instruments, we then go through some basic bond mathematics and introduce basic concepts regarding rates of return.¹ Finally, the note provides an overview of the U.S. Treasury market as well as some national markets for other important domestic government bonds.

CLASSIFYING BONDS

At first glance, bonds appear to be simple contracts between a lender and a borrower by which the borrower promises to repay a loan with interest. However, bonds can take on many additional features. The classification of a bond depends on its type of issuer, maturity, coupon rate, and redemption features. Figure A shows a possible classification.

Bond Issuers

The issuer of the bond is a major determinant of a bond's expected return and risk. Governments, municipalities, corporations, and many other entities issue various forms of debt to investors. The largest debt market in the world is the market for U.S. government bonds. Securities issued by the U.S. government are considered to have the lowest default risk of any issuer—the likelihood of the U.S. government defaulting on its bonds is considered extremely small.

Figure A Bond Classification

Source: Casewriter.

In addition to bonds ...