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Bonds
Bond markets are important components of capital markets. Bonds are
fixed-income securities-securities that promise the holder a specified set of
payments. The value of a bond (like the value of any other asset) is the
present value of the income stream one expects to receive from holding
the bond. This has several implications:
1. Bond prices vary inversely with market interest rates. Since the
stream of payments usually is fixed no matter what subsequently happens
to interest rates, higher rates reduce the present value of the expected
payments, and thus the price.
2. Bonds are generally adversely affected by inflation. The reason is
that higher expected inflation raises market interest rates and therefore
reduces the present value of the stream of fixed payments. Some bonds
(ones issued by the Israeli government, for example) are indexed for inflation.
If, for example, inflation is 10 percent per year, then the income from
the bond rises to compensate for this inflation. With perfect indexation the
change in expected payments due to inflation exactly offsets the inflationcaused
change in market interest rates, so that the current price of the bond
is unaffected.
3. The greater the uncertainty about whether the payment will be
made (the risk that the issuer will default on the promised payments), the
lower the "expected" payment to bondholders and the lower the value of
the bond.
4. Bonds whose payments are subjected to lower taxation provide investors
with higher expected after-tax payments. Since investors are interested
in after-tax income, such bonds sell for higher prices.
The major classes of bond issuers are the U.S. government, corporations,
and municipal governments. The default risk and tax status differ
from one kind of bond to another