Bonds are negotiable debt instruments issued, in capital markets with the purpose of raising capital. Investors who acquire bonds are lenders to the issuers. Particularly, investors lend some amount of money, the principal, to the borrower. In return, the borrower promises to make periodic interest payments (coupon payments) and to pay back the principal at the maturity of the loan. The purchaser of the bond has a claim against the issuer, but no corporate ownership privileges, as stockholders do.
The par value represents the face value of a bond and the coupon rate refers to the actual interest rate on the bond. A zero-coupon bond makes no payments, but instead it is issued at a considerable discount to par value. The maturity date of the debt as well as the terms and conditions of repayment are determined in advance.
Features of bonds
The most important features of a bond are:
Nominal, principal, par or face amount: the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end. Some structured bonds can have a redemption amount which is different to the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.
Issue price: the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.
Maturity date: the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. In the market for U.S. Treasury securities, there are three groups of bond maturities:
- short term (bills): maturities up to one year
- medium term (notes): maturities between one and ten years
- long term (bonds): maturities greater than ten years
Coupon: the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic.
Coupon dates: the dates on which the issuer pays the coupon to the bond holders. In the U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.
Callability: Some bonds give the issuer the right to repay the bond before the maturity date on the call dates (call options). These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
Putability: Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates (put option).
Call dates and Put dates: the dates on which callable and putable bonds can be redeemed early.
Types of bonds
Note that there are different types of a bond (such as Government Bonds (Treasuries), Municipal Bonds, and Corporate Bonds). Corporate bonds are characterised by higher yields because there is higher probability of a firm defaulting than a government (riskier than Government Bonds). The upside is that corporate bonds can be the most rewarding bonds due to the risk that investors must take on. Investors should also consider the quality of a bond. The higher the quality, the lower the interest rate investors receive.
- Government Bonds: Bonds issued by a government are called Treasuries. Treasuries are considered to be the safest bond investments since a government backs them and it is highly unlikely that a situation of default will occur. However, Treasuries with long maturities have more potential for inflation and credit risk.
- Municipal Bonds: Municipal bonds are debt obligations of state or local governments. The funds may be used to support general governmental needs or special projects. Municipal bonds are considered riskier investments than Treasuries.
- Corporate Bonds: Corporate bonds are debt instruments issued by private corporations. Corporate bonds come in various maturities. They are considered the riskiest of the bonds because there is much more of a credit risk with corporate bonds, but this usually means that the bondholder will be paid a higher interest rate. Corporations with low credit ratings issue bonds too, and these are speculative products called junk bonds.
The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond:
- Convertible Bonds: are bonds that may be converted into another form of corporate security, usually shares of common stock. Conversion only occurs at specific times at specific prices under specific conditions and this will all be detailed at the time the bond is issued. They are equivalent to a regular bond plus a warrant. They allow the company to issue debt with a lower coupon than otherwise.
- Fixed rate bonds: have a coupon that remains constant throughout the life of the bond.
- Floating rate notes (FRN): have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor.
- Zero-Coupon Bonds: These are bonds that do not pay interest periodically, but instead pay a lump sum of the principal and interest at maturity.
- Inflation linked bonds: in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation.
- Asset–backed securities: are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS’s), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
- Subordinated bonds: are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities.
- Perpetual bonds: are also often called perpetuities or ‘Perps’. They have no maturity date.
- Bearer bond: is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen.
- USA Bonds: In the US, bonds of maturity less than one year are called bills and are usually zero coupon. Bonds with maturity 2 to 10 years are called notes. They are coupon bearing with coupons every six months. Bonds with maturity greater than 10 years are called bonds, and they are coupon bearing. Bonds traded in the US foreign bond market but which are issued by non-US institutions are called Yankee bonds.
Standard & Poor’s and Moody’s Investors Service assign credit ratings to governments and corporations which provide the basis for assessment of issuer’s creditworthiness. The ratings for bonds are in the table below. The ratings represent greater default risk as you read down the table. In general high-yield bonds are bonds with speculative characteristics and are rated with a low credit rating. These bonds carry a coupon that is relatively high to reflect the higher level of risk. Other factors remaining equal, bonds with a higher credit rating generally offer a lower interest rate.
The “quality” of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors. These bonds are also called junk bonds.
|Quality||Moody’s||Standard & Poor’s|
|High Quality||Aa1, Aa2, Aa3||AA+, AA, AA-|
|Upper-medium grade||A1, A2, A3||A+, A, A-|
|Medium grade||Baa1, Baa2, Baa3||BBB+, BBB, BBB-|
Trading bonds may not be suitable for all investors. Although bonds are often thought to be conservative investments, there are numerous risks involved in bond trading. If you are uncomfortable with any of the risks involved, you should not trade bonds.
Credit risk: When you purchase a corporate bond, you are lending money to a company. There is always the risk that the issuer will fail to make interest or principal payments when due or the issuer can go bankrupt. If this happens, you will not receive your investment back. This is a risk of which you must be aware. Credit risk is figured into the pricing of bonds.
Prepayment risk: Prepayment risk involves the scenario where an issuer “calls” a bond. If this happens, your investment will be paid back early. Certain bonds are callable and others are not, and this information is detailed in the prospectus. If a bond is callable, the prospectus will detail a “yield-to-call” figure. Corporations may call their bonds when interest rates fall below current bond rates.
A “put” provision allows a bondholder to redeem a bond at par value before it matures. Investors may do this when interest rates are rising and they can get higher rates elsewhere. The issuer will assign specific dates to take advantage of a put provision. Prepayment risk is figured into the pricing of bonds.
Inflation risk: Inflation risk is the risk that the rate of the yield to call or maturity of the bond will not provide a positive return over the rate of inflation for the period of the investment. In other words, if the rate of inflation for the period of an investment is six percent and the yield to maturity of a bond is four percent, you will receive more money in interest and principal than you invested, but the value of that money returned is actually less than what was originally invested in the bond. As the inflation rate rises, so do interest rates. Although the yield on the bond increases, the price of the actual bond decreases.
Interest rate risk: Changes in interest rates during the term of any bond may affect the market value of the bond prior to call or the maturity date. When interest rates rise, bond prices of already issued fixed interest bonds decline since new bonds are issued bearing higher rates of interest than the already issued bonds. And vice versa, the price of already issued bonds increases when market interest rates decline.
Liquidity risk: Depends on several factors, among which the issued volume, time remaining to maturity, market conditions and specific market rules. Some bonds may not be able to be sold easily without any price concessions. Liquidity risk should be the main concern of investors who do not wish to hold the bond until maturity.
Reinvestment Risk: The variability of reinvestment returns due to changes in prevailing interest rates is known as reinvestment risk. It is the risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. The longer the bond, the greater the reinvestment risk. The only kind of bond which doesn’t have any reinvestment risk is the zero coupon bond.
In summary the dealing in bonds may involve risks including but not limited to the following: credit risk, prepayment risk, market risk, country risk, liquidity risk, exchange risk (in the case of foreign currency bonds), inflation risk, interest-rate risk and reinvestment risk.