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Fixed Incomebeginner

Bond Basics and Classification

A bond is a contract in which the issuer borrows a fixed sum and promises scheduled coupon payments plus repayment of the face value, or par, at maturity. The coupon rate is fixed at issue and, applied to face value, sets the periodic interest payment. Bonds are classified by issuer (government, municipal, or corporate), by seniority and security (secured versus debentures, senior versus subordinated), and by features such as callable, putable, or convertible provisions. These contractual terms, recorded in the bond indenture, determine the cash flows an investor can expect and the risks attached to them.

Why it matters

A bond is an IOU with a fixed schedule written on it. The face value is the amount the borrower will hand back at the end. The coupon rate is the rent paid on that amount along the way, and because it is fixed at issue it never changes even when market rates move. Everything else in bond analysis grows from this simple promise. Who is making the promise tells you the credit risk, and the embedded options tell you who can change the deal early.

Formulas

Periodic coupon payment
C=c×FmC = \frac{c\times F}{m}
The annual coupon is the coupon rate cc times face value FF. With mm payments a year (usually two for semi-annual bonds), each payment is cF/mcF/m.

Worked examples

Scenario

A corporate bond has face value A$1,000, a coupon rate of six percent, and pays semi-annually. How much cash does the holder receive each period and over the bond’s life if it matures in five years?

Solution

The annual coupon is c×F=0.06×1000=60c\times F=0.06\times 1000=60. With two payments a year each coupon is 602=30\tfrac{60}{2}=30, paid every six months. Over five years there are ten coupons of A$30 plus the A$1,000 face value returned at maturity, so total cash received is Total=10×30+1000=1300\mathrm{Total}=10\times 30 + 1000 = 1300.

NoteThe coupon rate is fixed to face value, not to the price you pay, so the dollar coupon never changes even if the bond trades above or below par.

Common mistakes

  • ✗The coupon rate is the return you earn on a bond. The coupon rate only fixes the cash payment relative to face value. The return you earn depends on the price you pay, which is measured by yield to maturity.
  • ✗Face value is what you pay to buy the bond. Face value is the amount repaid at maturity and the base for coupons. The purchase price can be above or below it depending on market rates.
  • ✗All bonds are low-risk because governments back them. Only sovereign and high-grade issuers carry low credit risk. Corporate and subordinated bonds can default, and ranking in the capital structure matters.
  • ✗A callable bond is always better for the investor because of its extra feature. A call option benefits the issuer, who can redeem early when rates fall, capping the investor’s upside, so callable bonds offer a higher yield to compensate.

Revision bullets

  • •A bond pays scheduled coupons plus face value at maturity
  • •The coupon rate is fixed at issue and applies to face value
  • •Classify by issuer, by seniority and security, and by embedded options
  • •Callable and putable features shift who can end the deal early
  • •The indenture records all contractual terms and protections

Quick check

A bond has A$1,000 face value and an eight percent annual coupon paid semi-annually. Each coupon payment is

A call provision in a bond indenture primarily benefits

Connected topics

Money MarketBond PricingBond YieldYield CurveSecuritization

Sources

  1. Brailsford, Heaney & Bilson (2015), Ch. on fixed-interest securities
    Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.
    Defines bond structure, coupon, face value, and the main classification schemes.
  2. Bodie, Kane & Marcus (2021), Ch. 14
    Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.
    Describes bond indentures, issuer types, and embedded option features.
How to cite this page
Dr. Phil's Quant Lab. (2026). Bond Basics and Classification. Derivatives Atlas. https://phucnguyenvan.com/concept/im-bond-basics
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