A bond is a financial asset, more precisely a fixed-income instrument, representing the lending of money by an investor to a borrower. The borrower issues or sells bonds to the lender to raise money, and the bond is the proof of this transaction.
- The investor is called a bondholder and lends money to the corporations, government, or other institutions who issue the bond.
- On one side, the primary purpose of issuers is to raise funds for various projects or investments. On the other side, the bondholder wants to invest in bonds to generate a fixed income in the future.
- Bonds can be traded in the financial markets as financial assets.
- Bonds are often considered a fixed-income instrument because most issuers pay a fixed interest rate to bondholders, and on the maturity date; the entire principal amount needs to be repaid.
- However, bonds also have the risk of default: the issuer may either not pay the due amount on time, or not pay it back at all.
Let's use the Swiss National Bank's document on public bonds updated on October 28, 2020, as an example.
For the CH0111999816 bond, its issue date was in 2010 and its maturity date is on April 28th, 2021, with a total issue price of CHF 4,258.451 million and 2% of the interest rate. It means that the Swiss National Bank is obligated to pay the investor a 2% interest as well as the total face value for CHF 4,258.451 million at maturity, on April 28th, 2021.
Tell me more.
- What is a bond?
Issuing bonds is a way for a company or government to raise funds.
The bond issuer is asking for money and in returns, he will pay interest in addition to the full amount of the bond at the due date. The investor, or bondholder, will accept to give money that he will not be able to use – unless he sells the bond to another investor – in exchange for a fixed income and a final repayment at the due date.
What we call a bond is the proof of this lending transaction. It is like a small piece of paper with specific details about the loan such as the par value, the interest rate, and the maturity date of the bond. As mentioned above, these bonds can be bought and sold between investors. When you do this, you are basically buying or reselling the contracted debt agreement, along with the interest rates and final reimbursement that come with it.
The Issuer is obliged to make specified payments to bondholders at the selected date following the payment details. If he does not, the bond is considered defaulted, which, depending on the agreement, can cause additional damages and repayments.
Generally, the Issuer is obliged to pay interest to the bondholder for a specified period, e.g., a coupon bond pays interest half-yearly. When the bond matures, the Issuer needs to pay the bondholder's equivalent value. The amount of interest due is the interest rate multiplied by the par value.
Bond prices are inversely proportional to interest rates: when the price of a bond rises, interest rates of the bond fall, and when the price declines, the interest rates go up.
Note that there are also zero-coupon bonds that do not have interest rates, meaning that the investor will only receive the repayment of the par value at the maturity date. Usually, the value of these bonds is less than the par value, which means that the bondholders are remunerated by the difference between the price for which he acquired the bond and the final reimbursement. For example, a company could issue a zero-coupon bond with a $100 par value but sell it for $90. The investor will therefore not receive interests but make a $10 profit at the end of the lending period.
2. Who issues bonds?
Corporations issue bonds to raise funds for their daily operations, purchase of machinery and equipment, development of new projects, etc. Corporations can also raise funds through bank loans. Still, sometimes the funds raised by bank loans are often insufficient to meet the company's capital needs, so companies raise funds by borrowing from the broader public through the issuance of bonds. They could also issue stocks, but although this is money they will not have to pay back, they are also giving away part of their company. With bonds, they can keep full control and just get access to the needed cash.
Bonds issued by governments are also known as government bonds, and the creditworthiness of the government determines the risk of government bonds. In some developed countries, governments issue a lot of government bonds that are considered risk-free or low-risk financial products due to their high creditworthiness. The government issues bonds to cover various investment costs, which can be schools, roads, swimming pools, or parks.
3. How does it work
Many corporate and government bonds are publicly issued; other bonds are traded only over-the-counter (OTC) or privately between borrowers and lenders, which means they do not appear on the public market.
Bonds can be traded on financial markets as financial assets, like stocks. After bonds are issued, the initial bondholder can sell them to other investors. Investors can buy the bonds directly from the government or the corporate issuing them or go on the secondary market. It is important to note that the borrower (bond’s issuer which can be the company or the government) can also repurchase the bonds it issued, under various conditions.
4. Different types of bonds
Based on the bond's issuer, we can categorize bonds into three types of bonds, namely government bonds, corporate bonds, and international bonds.
Government bonds are issued by the central or federal government and local governments. Two typical bonds are treasury notes and treasury bonds.
- Treasury notes are medium-term bonds with a maturity between one and ten years, and it provides a fixed coupon return. It offers semiannual coupon payments. These are some of the shorter-term bonds
- Treasury bonds or T-Bonds are long-term bonds with maturities ranging from 10 to thirty years. T-Bonds usually pay interest or coupons every six months as well. These bonds help make up for shortfalls in the government budget. They also help to adjust the monetary policy of the country.
Similar to a government bond, a corporate bond is issued by a company to raise money. Bonds are usually given different levels for safety by the rating agencies in the United States. The three major bond rating agencies are Standard & Poor's, Moody's, and Fitch. Usually, a bond with an A rating is safer than a bond with a B rating or lower.
Corporate bonds can be subdivided into the following four types, depending on their characteristics.
- Convertible bonds are bonds that allow bondholders to exchange their bonds for stocks at a given ratio. Convertible bonds have lower interest precisely because there is added value in this possibility. There are benefits for both company and investor: The company has obtained a lower cost of financing and the investor has the option to convert its bondsman into stocks.
- Zero-coupon bonds do not pay any interest in coupons and are issued at a price below its par value. The issuer is not required to pay interest to the bondholder but must pay the par face value at maturity. The bondholders can earn the difference between the par value and the issue price.
- A callable bond is a bond that can be redeemed by the issuer before the maturity date of the bond. A callable bond is riskier than a non-callable bond under the same conditions because it is more likely to be redeemed by the company when its value increases.
- Puttable bonds allow bondholders to sell them or sell them back to the company before the bond matures. It can be valuable for investors concerned that the bond’s value may depreciate or believe that interest rates will rise and want to get their principal back before the bond depreciates.
There are two types of International: foreign bonds and Eurobonds.
- Foreign bonds are issued by borrowers in countries other than those where the bonds are being sold. For example, bulldog bonds are issued bonds in pounds sterling issued by foreign companies in the U.K., and samurai bonds are bonds in yen issued by foreign companies in Japan.
- Eurobonds, in contrast, are bonds denominated in the currency of the issuer and sold in other countries, with the caveat that the currency is not just the euro. For example, the Eurodollar bonds are U.S. dollar bonds sold outside the United States, and Euro yen bonds are yen bonds sold outside of Japan.
5. What are the characteristics of a bond?
The characteristics of a bond include:
The par value: which is the value of a bond at maturity and the issuer also uses it as a reference for calculating interest. It is the amount to be paid at the end of the contract.
The issue price: which is the original price at which the bond was issued. When it is below the par value, it is called a discounted issue, while when it is above the par value, it is called a premium issue.
The interest rate: is a fixed rate indicated by the bond issuer to the bondholder on a specified date; it can also be seen as the borrower's cost of borrowing and is also seen as a gain of the holder, his remuneration to payback his opportunity loss of lending money.
The maturity date: which is the point in time on which a bond matures and on which the bond issuer is obliged to pay the bondholder the full amount of its par value.
6. Bond pricing
Because bondholders will receive the interest and par value of the bond in the future, the issue price that investors are willing to pay for these future payments depends on the money's future value versus the present value of the money.
Therefore, when investing in a bond, investors should look at the interest component and compare the market interest rate and the discount rate to get a better view of the bond's return.
After the bond completes its initial issuance, investors can trade the bond on the secondary financial market. In the secondary market, the price of the bond is inversely proportional to the yield. The higher the yield, the lower the price of the bond, and vice versa.
7. What are the risks of bonds?
Bonds, as financial products, also have investment risk. In general, bonds are less risky than stocks but riskier than bank deposits. The most significant risk in bonds is the risk of default.
The default is a bond issuer's failure to pay interest to bondholders or to repay the entire principal amount on the maturity date. It happens mainly when a company or government goes bankrupt.
Note that if the company is in bankruptcy, the bonds are entitled to be repaid first, as the debt comes before capital by law. This is because the company has no legal obligation to repay the shareholders, but it should repay the bondholders. However, once the company has declared bankruptcy, the bondholders may not recover all of their money. So make sure that your investments are safe, and that you do not invest in a company on the verge of financial collapse.