Fixed-income markets are populated with a vast range of instruments. In the present chapter, we
provide a typology of the most simple of these instruments, namely bonds and money-market
instruments, and describe their general characteristics.
General Characteristics of Bonds.
Definition of a Standard Bond.
A debt security, or a bond, is a financial claim by which the issuer, or the borrower, is committed
to paying back to the bondholder, or the lender, the cash amount borrowed, called principal, plus periodic interests calculated on this amount during a given period of time. It can have either a standard or a nonstandard structure. A standard bond is a fixed-coupon bond without any embedded option, delivering its coupons on periodic dates and principal on the maturity date.
For example, a US Treasury bond with coupon 3.5%, maturity date 11/15/2006 and a nominal
issued amount of $18.8 billion pays a semiannual interest of $329 million ($18.8 billion×3.5%/2)
every six months until 11/15/2006 included, as well as $18.8 billion on the maturity date. Another
example would be a Euro Treasury bond with coupon 4%, maturity date 07/04/2009 and a nominal issued amount of Eur11 billion, which pays an annual interest of Eur440 million (Eur11 billion×4%) every year until 07/04/2009 included, as well as Eur11 billion on the maturity date.
The purpose of a bond issuer (the Treasury Department, a government entity or a corporation)
is to finance its budget or investment projects (construction of roads, schools, development of
new products, new plants) at an interest rate that is expected to be lower than the return rate of
investment (at least in the private sector). Through the issuance of bonds, it has a direct access to the market, and so avoids borrowing from investment banks at higher interest rates. In the context of financial disintermediation, this practice tends to increase rapidly. One point to underscore is that the bondholder has the status of a creditor, unlike the equity holder who has the status of an owner of the issuing corporation. This is by the way the reason why a bond is, generally speaking, less risky than an equity.
Bond securities are usually quoted in price, yield or spread over an underlying benchmark bond.
Bond Quoted Price The quoted price (or market price) of a bond is usually its clean price, that
is, its gross price minus the accrued interest. We give hereafter a definition of these words. Note
first that the price of a bond is always expressed in percentage of its nominal amount.1 When an
investor purchases a bond, he is actually entitled to receive all the future cash flows of this bond,
until he no longer owns it. If he buys the bond between two coupon payment dates, he logically
must pay it at a price reflecting the fraction of the next coupon that the seller of the bond is entitled to receive for having held it until the sale. This price is called the gross price (or dirty price or full price). It is computed as the sum of the clean price and the portion of the coupon that is due to the seller of the bond. This portion is called the accrued interest. Note that the accrued interest is computed from the settlement date on.