Bond Basics

Bond: Definition

A bond is nothing more than an IOU.  You, as the lender of funds, enter into an agreement with an "issuer" of bond securities which entitles you to periodic interest payments, or coupon payments, which will continue for an agreed up on period of time as compensation for the funds borrowed.  Upon maturity (bond expiration date), the bond issuer will repay the original loan amount back to the lender.

Fundamentals of Bond Math

To truly understand bonds, you need to have an understanding of a few key metrics that will help you analyze a bond price more accurately.  These analytics will be at the base of your analysis.

Cash Flows

Bonds generate cash flows from three key sources:  coupon payments which can be paid anywhere from monthly to yearly, bond price appreciation or depreciation, and coupon re-investment, or "interest on interest". 

Bond Ladders, barbells, and bullets are strategies that will help the investor balance their bond portfolios to achieve their desired result.  The terminology of these strategies actually reflects the character of that strategy.  For example, a bond ladder will enable the bond investor to set up a bond re-investment strategy, in steps.  The barbell approach resembles a barbell in that bonds are purchased heavily in the short end and the long end.  Medium term notes are left out of the mix.  Finally, with the bullet strategy, each bond will share the same maturity date.  They will typically start at different intervals, but they all will mature together. 

Let's review each of these concepts in more detail:

What does a bond duration measure?

Duration is the weighted average term to maturity of a bonds cash flows and therefore, is a valuable tool in assessing bond price sensitivity to interest rate shocks. It is the most common technique for quantifying this sensitivity and is generally used to approximate changes in the price of the bond for every 100 basis point change in yields( modified duration). As a general rule, the greater the value of duration, the more price volatility results from interest rate movements.

Let's take a look at the formula that Frederick Macaulay devised to calculate duration.

What is Convexity?

Remember, as bond yields go higher, price goes lower.  This relationship between price and yield has a convex structure in nature.  The term used to describe this relationship is also known as convexity.  Notice in the diagram below, we have drawn a tangent line a yield Y*.  This tangent line is very similar to the concept of duration and represents the rate of change in price as interest rates change.  When the steepness of this tangent line increases, so does the duration.

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