What are bonds?

Bonds are debt securities that are issued by corporations or governments to finance new and ongoing projects. The bond market is where the companies and governments issue new debt. Bonds can be considered as funds lent by the investors to the company or government for regular interest payments. Therefore, bonds act as a loan that has been obtained by dividing and selling the debt as multiple small units to investors. The bonds are chosen by the investors based on the company ratings. The rating that shows the company’s credit quality is called the investment grade.

Similar to a loan, bonds have a maturity date by which the company has to repay the principal amount to the investors. The amount that is paid at maturity by the company is called the face or par value. The interest that is paid to investors between the date of issue and maturity date are called coupon payments. This coupon payment is determined by the coupon rate. The coupon payments are generally paid annually or semiannually.

Key characteristics of bonds

To maximize their returns, the investors compare and consider various important characteristics of bonds.

Issuers

Issuers are traditionally companies or governments. Bond issuers are considered borrowers as they obtain funds from the investors to finance projects. Bond issuers must pay interest periodically according to the interest rate to the bondholders until the date of maturity. On reaching the date of maturity, the issuer must repay the principal to the investor.

Bondholders

Bondholders are investors who purchase the bonds issued by companies or governments. Bondholders are considered creditors as they lend money to finance projects. The bondholders receive coupon payments according to the interest rate during the time they hold the bonds. The principal amount invested is paid back to the bondholders on the date of maturity.

Maturity date

Maturity date refers to the date at which the principal amount of the bond must be repaid to the investor. The maturity date of the bond is predetermined and mentioned on the debt instrument at the time of issue. Once the bond reaches maturity, the coupon payments cease and the contract between the two parties comes to an end.

Face value or Par value

Face value refers to the original cost of the bond that must be paid to the bondholder at maturity. The face value of the bond is different from the market value of the bond. This is because the market price of the bond is subject to different economic conditions. If the market value is above the face value, the bond is considered to be selling at a premium. The face value and the interest rate are used to calculate the interest payments.

Coupon rate

Coupon rate or nominal yield refers to the interest rate at which coupon payments are made. The coupon rate or interest rate is calculated as a percentage of the par value. The interest rate is generally determined by the central bank. The interest rate could be fixed or floating. Floating rates generally move in accordance with money market rates such as LIBOR (London Inter-Bank Offered Rate).

The yield

The yield of a bond refers to the total return made on the bond. Yield to maturity is different from the coupon rate of the bond. While the coupon is calculated as a percentage of the par value for interest payment, the yield covers the interest payments along with gains on sale and reinvestment. The yield to maturity can be used effectively to compare different bonds before investing. The yield to maturity is the highest in high-yield bonds which offer higher returns with low volatility.

Types of bonds

The characteristics of the bonds are not fixed, and they vary as per the type of bond issued.

The following are some of the bonds that show differences in characteristics compared to regular bonds.

Zero-coupon bonds

Debt security without any interest payments is called zero-coupon bonds. These bonds are issued at a discount but redeemed at the face value when it reaches maturity. Therefore, the characteristic ‘coupon rate’ does not exist for these bonds as there are no coupon payments in their lifetime.

Callable bonds

Call provisions are available in bonds that give the right to the issuer to repurchase the bonds at any time during the contract. Through callable bonds, the company can pay off its debt before maturity. The call option is exercised by the issuers when the market rates are low. This is because the low market rate reduces the repurchasing cost for the company. The company then issues new bonds at the lowered interest rates. Therefore, the characteristic ‘maturity’ is different for callable bonds compared to regular bonds as the issuers can repay and cease the contract before it reaches maturity.

Puttable bonds

The holder of a puttable bond has the right to ask the issuer to redeem the bond any time before the maturity date. Puttable bonds thereby are the opposite of callable bonds. If the bondholder exercises the put option, the par value of the bond is received on the date redeemed. Bondholders may face the risk of falling bond value due to a rise in interest rates. Therefore, through a put option, the bondholder can reduce loss by asking the issuer to pay the par value of the bond. Hence, the feature of maturity is optional in the case of puttable bonds.

Convertible bonds

The holder of a convertible bond has the option to exchange their bonds to obtain company shares. Since the bondholders have an additional feature, the interest rate is relatively low for these bonds. Therefore, the characteristics of coupon rate, face value, and maturity are subject to change for these bonds.

Perpetual bonds

Perpetual bonds are debt securities that have no maturity date. This means that the bondholder cannot redeem the principal amount. The coupon payments paid by the issuer go on forever. This creates a steady income for the bondholder. Characteristics such as maturity and face value do not exist for these bonds.

Limitations

Credit risk is always present in the case of debt instruments issued by companies. The issuer of the bond can fail to pay the interest or principal amount due to a shortage of funds. Credit risk is however less likely to happen in the case of government bonds. Although, a lower risk bond also indicates a lower return. There is also a possibility of event risk where a company may experience an unforeseen issue that affects their cash flows. Unstable cash flows can impact periodic coupon payments. There is also a liquidity risk present in bonds. Unlike shares, bonds cannot be easily sold or purchased.

Bonds could be an effective investment and bonds could provide a fixed income given that the above risks are accounted for.

Context and Applications

This topic is significant in the professional exams, undergraduate and graduate courses such as

• Chartered Financial Analyst (CFA)
• Bachelor of Science in Finance
• Masters of Science in Finance

Practice Problems

Question 1: Which of the following is also a bondholder of a company?

1. 1. Debtor
   2. Creditor
   3. Owner
   4. none of the above

Answer: (b) Creditor

Explanation: Bonds are debt instruments that are similar to a loan. Therefore, the bondholder who lends money to the corporation is considered a creditor.

Question 2: Which of the following bonds can be exchanged for company shares by the bondholders?

1. 1. Callable bonds
   2. Perpetual bonds
   3. Convertible bonds
   4. All the above

Answer: (c) Convertible bonds

Explanation: As the name indicates, the convertible bonds can be converted to company shares by the bondholders.

Question 3: Which of the following key features can be used to compare bonds before investing?

1. 1. Yield to maturity
   2. Maturity date
   3. Face value
   4. Par value

Answer: (a) Yield to maturity

Explanation: The yield of the bond indicates the total return on investment including interest, compounding, and gain on selling. Therefore, it is used to compare different bonds before investing.

Question 4: Which of the following bonds have an interest rate that fluctuates with the London Inter-Bank Offered Rate?

1. 1. Fixed-rate bonds
   2. Floating-rate bonds
   3. Zero-coupon bonds
   4. Puttable bonds

Answer: (b) Floating-rate bonds

Explanation: As the name indicates, the interest rate on a floating-rate bond fluctuates with market rates such as London Inter-Bank Offered Rate.

Question 5: What is the price of the bond if its market value is higher than the face value of the bond?

1. 1. Premium
   2. Discount
   3. Fair value
   4. None of the above

Answer: (a) Premium

Explanation: The market price of the bond reflects the true bond price. A bond is said to be priced at a premium if the market value of the bond is higher than that of the face value.

Common Mistakes

While companies issue bonds similar to shares, it is incorrect to assume that bondholders and shareholders are treated similarly. Shareholders are owners of the company while bondholders are considered creditors of the company. In the case of insolvency, bondholders are given the first preference in repayment compared to shareholders.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Time value of money
• Long-term financing
• Debt instruments
• Short term financing