What is a Bond?
A bond is like a loan given to a borrower by an investor, the borrowers being the corporate or the government entities. Many investors invest in bonds to diversify their investment portfolio as a strategy to deal with market volatility and to reduce overall portfolio risk.
Bonds belong to a group of financial instruments called Fixed Income and are usually traded through brokers.
Who issues bonds?
Bonds are usually issued by corporations or governmental bodies when they need large sums of money to finance or fund large projects. These entities use these bonds to borrow money from the public. For example, in the event of any adversity, like the recent Covid-19 pandemic or a war, the governments may issue bonds to borrow money from the public to cover the contingency expenses and the cost of operations of various projects. The investors buy these bonds in the primary market with an expectation that the principal amount will be returned to them later with a certain amount of interest or increment.
How do bonds work?
The bond contract specifies the terms of the loan, the interest payment, and the maturity date. When the bond matures, the bond issuer is expected to repay the principal amount or the face value of the bond along with the interest to the bondholder or the investor. Bonds are traditionally paid at a fixed interest rate. However, these days, floating or variable rates are also common. These bonds can be traded in the secondary markets before they mature at the end of the loan period.
Unlike stocks, there is a possibility that bonds can vary depending on the terms of the contract associated with the bond, which outlines the deciding characteristics of the bond issue. The investors must go through these terms of the contract carefully before investing. In particular, there are seven important characteristics to look for when considering investing in a bond.
Characteristics of bonds
When investing in bonds, the investor should look out for the following characteristics of the bonds.
- Face value/par value: It is the value that the investor or the bondholder will receive on the maturity date.
- Maturity date: It is the lifetime of the bond, or the date when the investor receives the principal or par amount of the bond from the company and the company's bond obligation ends. Based on the maturity date, bonds are often classified in three ways:
- Short-term bonds: Bonds that tend to mature within one to five years.
- Medium-term bonds: Bonds that tend to mature within two to ten years.
- Long-term bonds: Bonds that tend to mature within ten to thirty years.
- Secured/Unsecured: Bonds can be classified as either secured or unsecured.
- A secured bond is a bond where the company pledges specific assets, also known as collateral on the loan, to the bondholders in case it fails to repay the obligation. That means if the bond issuer defaults, the asset is then transferred to the bondholder or the investor.
- An unsecured bond also called a debenture, is not backed by any collateral. That means the interest and principal are only guaranteed by the company and the investors receive very little ROI in case the company fails, which makes this bond much riskier than the secured bond.
- Liquidation preference: As the company liquidates in the event of bankruptcy, it is expected to repay its investors in a particular order. After selling out all its assets, the firm must pay the senior debts first, followed by junior debts or subordinate debts. Stockholders get whatever is left.
- Coupon: The coupon, also called the coupon rate or nominal yield, represents the interest paid to bondholders annually/semi-annually. The coupon rate is calculated by dividing the annual payments by the face value of the bond.
- Tax status: Although most of the corporate bonds are considered as taxable income, some government and municipal bonds are tax-free or are not subject to taxation. However, such bonds offer lower interest rates than taxable bonds.
- Callability: A bond issuer can redeem bonds before the maturity date if such a provision exists. This usually happens when the interest rates allow the company to borrow at a better rate.
Types of bonds
The different types of bonds are:
- Traditional bond: Traditional bond allows investors to draw the entire principal at a single time after the bond's maturity date.
- Callable bond: A callable bond provides an option to the bond issuer to redeem the bond before its maturity date.
- Puttable bond: A puttable bond comes with an embedded option that allows investors to sell their bond before the maturity date.
- Fixed-rate bond: In fixed-rate bonds, the coupon rate remains the same throughout the term of the bond.
- Floating rate bond: In floating rate bonds, the coupon rate fluctuates throughout the term of the bond.
- Mortgage bond: Mortgage bonds are backed by real estate assets and equipment as collateral in case the company defaults on the payment.
- Zero-coupon bond: A zero-coupon bond comes with a zero-coupon rate, which means the investor will receive the par value of the bond on maturity.
- Serial bond: A serial bond is a bond in which the loan amount is paid to the investor in small installments every year.
- Extendable bond: Extendable bonds allow the investors to extend the maturity period of the bond.
- Climate bond: Climate bonds are issued by governments, corporations, or multi-national banks to raise funds for climate change solutions.
- War bond: War bonds are issued by the governments to raise funds for defense operations in the event of wars.
- Treasury bond: Treasury bonds are issued by the national governments at a low-interest rate but are considered safe and risk-free since these are not exposed to default risk or credit risk. The Treasury yield is the effective interest rate that the U.S. Government pays on these T-bonds and other Treasury securities.
What are bond funds and bond ETFs?
Both Bond Funds and Bond ETFs (exchange-traded funds) invest in a pool of bonds. Although a bond ETF also holds bonds alone, these can be traded on an exchange similar to how stocks are traded.
Yield is the measure of return expected on an investment or the amount of return an investor receives when the bond period ends. It is usually expressed as an annual percentage. For example, a 7% yield indicates that the investment provides a 7% return each year. The most often used measurement is the Yield to Maturity (YTM).
Yield to maturity (YTM)
Yield to maturity is the measure of the return on a bond if the investor holds it till the maturity date. Investors should inquire about the yield to maturity of bonds before investing in them. Investors can then compare different securities and the returns expected out of those securities. The yield is higher when the coupon rate is higher and the yield is lower when the bond's price is higher.
The formula for calculating the yield to maturity is given below:
C – coupon rate
FV – face value of the bond
PV – present value of the bond
t – maturity time of the bond
Note: This formula gives only the approximated YTM. To calculate the true YTM, the investor would populate the formula using several rates for the current value and would arrive at the true YTM using the trial-and-error method only.
The relationship between yield and the time of maturity can be represented graphically using a yield curve. The shape and slope of the yield curve indicate the future interest rate changes and economic activity. The different types of yield curves are given below.
- A normal yield curve is the one in which long-term bonds have a higher yield in comparison to the short-term ones owing to the risks associated with time.
- An inverted yield curve means long-term yields falling below short-term yields, which can be considered as a sign of an upcoming recession.
- A steep yield curve means that the long-term yields are rising at a faster rate than the short-term yields.
- A flat yield curve means that all maturities will have similar yields.
- A humped yield curve suggests that the medium-term yields are greater than both the short-term and the long-term yields.
Risks in Bonds
Although bonds are relatively safe investments, they do come with certain risks. The following are the most common risks associated with bonds.
- Interest rate risk: These risks come when rates change significantly from what the investor had expected. When rates rise, bonds tend to fall, and vice-versa. A significant decline in rate may lead to prepayment. A significant rise in rate means the investor will be left with an investment that yields below the market rates. The risk is greater in the case of long-term bonds because it is harder to predict the nature of the market in the farther future.
- Credit risk/Default risk: It is the risk where the bond issuer fails to pay the bondholder the interest and principal amount timely as per the contractual terms of the bond. Hence, it is important that for an investor to consider the possibility that the company or the bond issuer may default on the debt. It is safer to invest in companies with greater cash flow compared to their debts.
- Prepayment risk: It is the risk where the bond will be paid off earlier than expected through a call provision. The company may use this provision to repay the obligation when interest rates decline substantially. In that case, investors are left to re-invest at a lower interest rate.
Investors and professionals use bond ratings to judge a company's ability to repay the interest and the principal. Some of the popular bond rating agencies are Standard & Poor's, Moody's Investors Service, and Fitch Ratings. These agencies assign ratings ranging from AAA to Aaa for bond issues that are very likely to be repaid and a rating of D for bond issues that are currently in default.
C – coupon rate
FV – face value of the bond
PV – present value of the bond
t – maturity time of the bond
Context and Applications
This course is significant for students pursuing undergraduate and graduate courses in the investment and finance sector.
- B. Com
- Equity Securities
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