Bonds Meaning Types Examples How They Work

Bonds Meaning

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Bonds are tradable units that can be exchanged in the secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more like stocks. Though they have a par value, they can be traded at a discounted or premium price. Further, bondholders have a stake in a business as they are entitled to the interest and repayment of principal on maturity. This privilege makes them more secure than stocks as an investment. However, unlike equity holders, they are not owners and have no claim in the company’s profits.

Key Takeaways

Bonds are the debt instruments issued by a government or a company to borrow funds from individual or corporate investors for a specific duration. In return, the issuer offers periodic interest to the holders. These securities have a face value which is their redeemable price. Also, the issuer provides coupon payments to the holders throughout the holding period. There are a variety of bonds like corporate, government, municipal, fixed-rate, floating-rate, convertible, zero-coupon, high-yield, etc.

How do Bonds Work?

A bond is simply a medium of loan for the companies and the government. The funds so accumulated by the issuer can be used to pay off debts, initiate new projects, or meet other financial requirements. However, lenders are individuals or institutions looking forward to making long-term investments to earn stable returns.

Such funds are treated similarly to loans and have a principal sum (issuance value), interest (coupon), and loan term (maturity period). Most of them offer a fixed interest rate at regular intervals, i.e., monthly, quarterly, semi-annually, or annually. But some have floating rates as well, though they involve higher risk.

Individuals and institutions can buy the new issuance via bidding in the auctions, visiting the Treasury Direct website, and from the brokers or issuing investment banks. However, prevailing bonds can be purchased by the investors in the secondary markets from the bondholdersBondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more.

Moreover, the investors can look for other options like index funds and exchange-traded funds for more diversified investmentDiversified InvestmentA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more. A buyer should always give due consideration to a bond’s credit rating and its expense ratioExpense RatioThe total expense ratio is the total investment cost to the investor who invests in a mutual fund, equity fund or exchange-traded fund. It included the transactional costs of investment, legal, management, auditor fees and many other miscellaneous operational expenses determining the final return on the investment.read more before investing in it. In addition, the previous years’ yield and coupon rate are equally important.

These instruments are prone to various types of risks, such as credit, liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, foreign exchange, inflation, corporate restructuringCorporate RestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more, volatility, and yield curve risks. The changes in their prices immediately impact the portfolio of securities as it offers relatively stable returns. Additionally, the price of a government bondGovernment BondA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income.read more is susceptible as it will depict the economic stability of the respective country. The credit rating agencies’ upgrade or downgrade can also impact its prices.

Characteristics

For the investors, bonds are long-term debt securities, while for the issuers, they serve as a source of generating funds or borrowing from investors. So let us now understand the various features that distinguish them from other investment vehicles:

Issuer: The company or government (city, state, or national authority) issuing debt instruments to borrow money from individuals and corporate investors is termed as an issuer.Par Value: Every bond has a face value written on it, which is the amount a bondholder is liable to receive on the maturity date.Market Value: It is the price at which the bonds trade in the secondary market.Coupon: The rate of interest offered by the issuer on these debt securities is termed the coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more. Also, the annual interest paid to the investors is the coupon value.Coupon Date: The date on which the investors receive periodic interest payment is the coupon date.Maturity Date: The date the bond can be redeemed is its maturity date. The maturity period of such debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more can be for short, medium, or long term.Yield: The percentage return an investor makes by holding a bond to maturity is termed its yield. Credit Rating: The top rating agencies such as Moody’s, Standard and Poor’s, and Fitch rate different bonds based on their risk level. The ones with high risk are scaled low and known as junk bonds.

Types of Bonds

A bond can be of multiple kinds based on its issuing party, coupon payment, flexibility, yield, etc. However, some of the common ones are discussed below:

Fixed-Rate: These instruments have coupon rates that remain constant throughout their life.Floating Rate: The coupon rates of these securities are linked to a reference interest rate, such as the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more (London Interbank Offered Rate) or U.S. Treasury Bill rate. Since these are volatile, they are classified as floating. For example, the interest rate may be defined as U.S. Treasury Bill rate + 0.25%. It gets recomputed on a periodical basis.Corporate: These are debt securities issued by the companies and sold to various investors. They can be secured or unsecured. The backing for them depends on the payment ability of the company, which in turn is linked to possible future earnings of the company from its operations. These are the aspects looked in by the credit rating agenciesCredit Rating AgenciesCredit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries.read more before giving in their confirmation.Government: These are issued by the national government promising to make regular payments and repay the face value on maturity. The terms on which the government can sell such securities depend on its creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more in the market.Municipal: These debt instruments are released by the nation, state, or cities to raise finances for their upcoming or running projects. The income from such securities is exempted from the state and federal tax liabilities.Zero-Coupon: They do not pay any periodical interest during their life. Instead, they are usually issued at a discount to the par value, making it an attractive investment. This difference is then rolled up, and the entire principal amount (par value) is paid on maturity. Financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more can also issue them by stripping off the coupons from the principal amount.High Yield: Such debt securities, also known as junk bonds, are rated below investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more by the credit rating authorities. So, to attract investors, the issuers offer a higher rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more. Since these are lower-grade instruments, they are expected to offer a larger yield. Investors willing to take a risk for higher yield opt for them.Convertible: It allows the holders to exchange them for specific equity shares. These are considered hybrid securitiesHybrid SecuritiesHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering.read more since they possess combined features of equity as well as debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more.Inflation-indexed: These debt instruments link the principal and the interest amount to the inflation indexes like the consumer price indexConsumer Price IndexThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark point.read more. Thus, they protect investors from inflation prevailing in the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more, thereby securing their investments.Subordinated: These are a class of unsecured corporate debt securities that have a lower priority than other instruments at the time of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more. The risk is higher than senior bonds. Once the creditors and senior bondholders are paid, the subordinated bondholders are compensated. Comparatively, they have a lower credit rating. Some examples of them are the debt instruments issued by banks, asset-backed securitiesAsset-backed SecuritiesAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more, etc.Foreign: These debt securities are issued by a foreign company in the domestic market to raise funds in the domestic currency. As most investors would be from the domestic market, it can benefit from a diversified portfolioDiversified PortfolioPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more. Moreover, the investors can also get foreign exposure in their respective portfolios—for instance, Bulldog and Samurai bonds.

Bond Pricing

The market value of a bond is the present value of the principal sum and the interest payments discounted at the yield to maturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond’s returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more (rate of return).

Market price = Present value of interest payments + Present value of principal amount

CV = Coupon valueP = Principal valuey = Yield to maturity raten = Number of coupon payments

Please note that the yield and price of the bondPrice Of The BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more are inversely related so that when the market rate rises, the price will fall and vice-versa.

Thus, the success of these securities is directly proportional to the yield they offer. Yield is the yearly return in percentage that the bondholders earn on such security.

Y = Yield

Case #1

For instance, if a bond was issued for $2000 with an annual coupon of $90, then its yield is:

Yield = (90/2000) *100 = 4.5%

Case #2

Now, assume that due to spontaneous increase in demand, the price rose to $2300, so:

Yield = (90/2300) *100 = 3.91%

Case #3

Similarly, if the price drops down to $1900, then:

Yield = (90/1900) *100 = 4.74%

Thus, from the above example, we can interpret that when the prices go up, the percentage yield falls, and when the prices decrease, the yield percentage goes up.

Bond Examples

One of the blooming high-yield European bond funds is the Schroder ISF EURO High Yield fund. Even amidst the Covid-19 conditions, this debt security fund performed well. Though the growth was slow, with various monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more reforms and rising inflation, it lived up to the investors’ expectations. Each unit is trading at 168.0569 Euros as of November 2, 2021. Also, the fund marked a 4.59% yield to maturity and generated a 4.52% return in five years. To gain more insight on this fund, check the Bloomberg website.

Another top-rated bond index fund is the Fidelity U.S. Bond Index that primarily includes the intermediate-term debt securities. These debt securities offer an SEC yield of 1.1% while its expense ratio is just 0.025%. The best part of this fund is its diversified portfolio with around 2300 different bonds (37% of which are U.S. treasuries), which provide fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more opportunities to the holders. Read more about it in the article published in Kiplinger.

Bond Indices

The bond index refers to a parameter for judging the performance of the bond market. The index is calculated by tracing a bundle of top-performing debt securities. Several such indices exist for the management of portfolios and measuring returns, such as:

Bloomberg Barclays U.S. AggregateCitigroup BIGMerrill Lynch Domestic MasterJP Morgan Global Index

They also act as a benchmark to measure the performance of different bond funds. This comparison enables fund managers to devise strategies to manage the funds effectively. The market price and interest payments of selected debt instruments form the basis of calculating the index.

Bonds Meaning#

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How do Bonds Work?#

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Types of Bonds#

Bond Pricing#

Bond Examples#

Bond Indices#

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