Bonds & annuities

bond is a promise made by a borrower to pay back a lender the face value of the bond at maturity, plus periodical interest payments.

...whereas a note is paid off in its entirety at maturity.

Annuities are the periodical payments that the borrower must pay to the lender.

These are the same amount each time!

Scenario: You takes out a 5-year bond from your local bank for $1,000 at a 5% stated annual interest rate.

Annuity = $1,000 x 5%
Annuity = $50

These $50 annuity payments are paid each of the 5 years of the bond!

The stated interest rate is written into the bond contract, whereas:

The effective interest rate is used to determine the true allotment of the annuity payments towards interest vs. bond liability. It's set by the market.

Compared to the stated interest rate, the effective interest rate can either be:

  • Higher (discount)
  • Lower (premium)
  • Same (par)

This determines how the bond selling price compares to its face amount.

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