Analysis of Asset Allocation

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Bonds - Major characteristics: Interest rate
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INTEREST: choose the one that fit your objectives

Unlike shares that may or may not pay dividend, Bonds pay interest that can be fixed, floating or paid at maturity. Interest are a percentage of the face value (principal amount) of the bond.

FREQUENCY

Interests are paid at a certain frequency. In the US, bonds often pay interest semiannually. In Europe, it is most often paid annually.

But other frequencies exist: monthly (often seen with mortgage back securities), quarterly,...

FIXED or FLOATING rate

As we will see in the price section, the rate paid by the bond has an influence on the price you get to purchase the bond.

Some bonds have a fixed rate. The interests the borrower (issuer) will pay you during the lifetime of the bond will not fluctuate or be influenced by the evolution of the market rates. We will see in the price section that the price volatility of such bonds are higher that the one of the floating rate bonds. Private investors usually purchase fixed rate bonds when they think that the interest rates will go down in the future. This of course must be compared to your financial objectives.

Other bonds have a floating rate meaning that at a certain frequency (usually the same as the one the issuer pays the interests) the rate is adjusted for a new period. The way the new rate is fixed is usually a spread against a base interest rate index such as rate on treasury bills or LIBOR. The LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short term loans. As the rate paid by the bond follows the market fluctuations (the borrowing conditions), the price of such bonds are less volatile but, on the other hand, if the market rates go down, you will get less interests in the future (and the reversal if market rates go up).

The last category is the one that has no periodic interest payments (rate is fixed to zero). Known as zero coupon bonds, this kind of bonds are sold at a discount from their face value. For example, you will pay 80 USD for a bond that will pay you 100 USD at the maturity date. Such bonds are a sub category of the fixed rate bonds and must be analyzed as such. Price volatility is comparable to fixed rate bonds. 

Once the interest type analyzed, you should look at the effective maturity.

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