Bonds

Fixed income security representing an investor's debt to a borrower.

A bond is fixed income security representing an investor's debt to a borrower.

It can be considered a promissory note between the lender and the borrower that outlines the loan's terms and installments. 

Companies, municipalities, states, and sovereign governments all use these to fund projects and operations. Bondholders are the Issuer's debtholders or creditors. 

The time limit when the loan's principal is scheduled to be paid to the owner is usually included in the bond specifics, as are the terms for the borrower's fixed or floating interest payments.

Businesses issue these to fund existing operations, brand-new initiatives, or acquisitions. Governments sell them to raise money and complement their tax collection. By purchasing, you become a debtor of the organization issuing the bond. 

A well-rounded investing portfolio should include a variety of, especially, investment-grade bonds, as they are generally lower risk than equities. 

These can provide a constant income stream during your retirement years while protecting your cash, helping to mitigate the risk of riskier assets like equities.

These are crucial to every investment portfolio, yet some investors no longer like them. Many have advised that investing in equities is the most acceptable long-term financial strategy for years.

Those who minimize the importance may pass up an opportunity to profit. 

Who is the Issuer of a bond?

These are a systematic way for governments and enterprises to borrow money. Governments must fund infrastructure projects. Typically, the cost of war also necessitates the need to acquire finances.

Similarly, firms frequently borrow to expand their operations, purchase land and equipment, embark on profitable ventures, and conduct research and development.

The challenge that large businesses have is that they often require significantly more capital than the normal bank can supply. Therefore they issue them to raise funds.

These offer a solution by allowing many individual investors to act as lenders.

Thousands of investors can lend a portion of the required funds through public debt markets. 

Furthermore, markets enable lenders to sell these to other investors or purchase them long after the original Issuer has raised funds.

Types of issuers:

  • Corporations

One of the main groups of these issuers is corporations. These are common forms of capital raising used by governmental and private organizations. 

These could include financing their ongoing operations or growing their current enterprises. 

Financial institutions, public sector organizations, and other private businesses are corporations. 

  • Governments 

A country's government may issue them to finance various social welfare programs or other investment purposes. 

Government issuers are typically thought to be less hazardous than corporate issuers. This is because they often use their revenue, such as taxes, to pay the interest on bonds and recoup the principle. 

  • Multilateral and supranational Entities

These are organizations that have no geographic location. For example, the world bank is on this list. Because of their reputation internationally, these issuers are also highly rated and less hazardous.

How do they operate?

Bonds, like stocks and cash equivalents, are fixed-income securities. As a result, they are one of the most prevalent asset classes that investors are familiar with.

Many corporate and government bonds are exchanged on the stock exchange; others are only traded over the counter or privately between the borrower and the lender. 

Companies and other entities may offer these directly to investors when they need money to fund new initiatives, maintain continuing operations, or repay existing debts. 

The borrower produces a bond that spells out the loan terms, the amount of interest that will be paid, and when the borrowed funds must be repaid. 

Bondholders receive a portion of the return for lending their money to the Issuer through coupon payment.

They typically have up to 30 years and offer a set interest rate that is paid throughout their life. They are often acquired in blocks of five or ten and have a face value of $1,000 each.

In most cases, institutions can acquire better conditions by issuing these instead of applying for bank loans. The word "bonds" is sometimes used confusingly. 

It is a long-term obligation that typically lasts more than ten years, according to the precise definition. However, it is common for the phrase to be used in a sense that also encompasses shorter-term maturities such as six weeks.

Characteristics

There are multiple characteristics, as each has its aspect. Usually, they branch into

  • Face value: Corporate bonds usually have a par value of $1000. On the other hand, government bonds' par value can be much more significant.
  • Interest: Based on the market norms, these pay interest every six months; sometimes, they might pay quarterly or monthly.
  • Coupon: Fixed-rate bonds usually have a fixed interest rate that pays a fixed amount over a year. Floating-rate come in two varieties. The annual interest rate is either fixed or linked to market rates.

Other types, such as Treasury bills, have an adjustable floating rate related to market rates. The investor profits if the Treasury bill yield rises. The opposite is true: if yields fall, the issuer benefits.

As a result, fixed-rate are deemed safer than floating-rate, while their yield may be smaller.

  • Maturity: Maturities can range from 1 day to 30 years.

 A bond with one-year maturity is far more predictable and consequently less dangerous than one with a 20-year maturity.

As a result, high-interest rates equal more extended periods of maturity. Longer-term bonds will also fluctuate more than shorter-term bonds.

  • Issuer: The Issuer's financial strength is your best bet for getting paid when it matures. For example, the governments of Canada and the United States are significantly more secure than any firm.

Their default risk–the possibility that the debt will not be repaid–is exceedingly low, to the point where they are termed risk-free assets. The rationale is that a government can always rely on taxation to generate future money.

On the other hand, a business must continue producing money, which is far from certain. This means to tempt investors. Firms must give a greater yield–this is the risk/return trade-off in effect.

 

  • Rating agencies: The bond rating system aids investors in determining the credit risk of a company or government.

Blue-chip corporations have a high rating, indicating that they are safer investments, whereas riskier companies have a low rating.

There are three companies that rate financial institutions, and they are listed below in the table.

Ratings
Moody'sS&P'sDBR'sRISK
AaaAAAAAAHighest Credit Quality
AaAAAAHigh Credit Quality
AAAStrong Credit
BaaBBBBMedium Grade Credit
Ba, BBB, BBB, BSpeculative
Caa,Ca,CCCC,CC,CCCC,CC,CHighly Speculative
CDDIn Default

types

A few of the types are:

 1. Corporate Bonds are debt securities issued using personal and public corporations; they are usually called investment grades.

These have a better credit score rating, implying much less risk than high-yield company bonds.

 2. High Yields: These have a decreased credit score rating, implying better credit score risk than investment-grade bonds and, therefore, provide better hobby costs in return for the elevated risk.

 3. Municipal Bonds: Debt certificates issued by states, cities, counties, and other government agencies.

The types of corporate bonds of local governments are as follows. 

  • General: These notes are not asset-backed securities. The Issuer has the authority to tax residents on payments to bondholders
  • Revenue: Instead of taxes, these bonds are covered by income from specific projects or funds. 

Some earnings bonds are non-recourse. Therefore, if the earnings stream is exhausted, bondholders are not entitled to the underlying earnings stream. 

  • Conduit: The government can issue conduit bonds on behalf of private organizations such as non-profit universities and hospitals. 

These borrowers usually agree to repay the Issuer, who pays the interest and principal of the bond.

If the conduit borrower fails to pay, the Issuer is usually not obliged to pay the bondholder.

4. US Treasuries: Used in the United States Treasury issued on behalf of the federal government. They enjoy the complete trust and approval of the US Government, making it a safe and popular investment.

How are they priced?

Investors need to be familiar with its pricing rules. These are not traded like stocks. The pricing mechanisms that drive bond market changes do not seem as intuitive as the rise in stocks and investment trusts.

This is because stocks are traded based on their future value. All bonds have a par value and can be traded at either par value, premium, or discount. Interest in bonds is usually fixed.

However, the current yield will fluctuate as its price changes. The price is determined by using a discount rate to discount the expected cash flow to date. 

The three main factors for its prices in the open market are maturity, credit quality, and supply and demand.

These are issued at the specified par value and traded at par if the current price is equal. When the bond is sold for more than the initial value, it's considered a premium. 

For example, a $1,000 bond sold for $1,100 is traded at a premium. However, discount bonds are the opposite and are sold at a lower price than the offered face value.

What is YTM?

Yield to maturity is the overall return of the bond until it matures. They are considered long-term bond yields but are expressed at an annual rate.

In other words, if an investor holds a bond to maturity, all payments are made on schedule and reinvested at the same rate. Therefore, it is the internal rate of return (IRR) of the investment in the bond. 

Yields to maturity are similar to current yields. This is because YTM takes into account the present value of future coupon payments on bonds. 

In other words, it takes into account the time value of money but not the simple calculation of the current rate of return.

YTM for discounted bonds that do not pay coupons is a good starting point for understanding some of the more complex issues of coupon bonds.

To determine whether purchasing bonds is a wise investment, yield to maturity can be quite helpful.

Investors can decide whether a bond is a good investment by comparing the YTM and the needed yield of a bond they are considering purchasing.

Example of a bond

Additional information

Bond lending has three significant benefits for businesses. The first and most crucial advantage of debt finance is that debt does not undermine the company's ownership, unlike equity finance.

 These can be issued without diluting the ownership of current shareholders. 

 Second, interest expense on bonds is tax-deductible. 

The company bears interest expenses to raise funds for the bonds, which are tax-deductible. Equity finance does not offer tax incentives. 

Third, debt finance can increase return on equity. This concept is often referred to as financial leverage

If the interest paid on a bond is less than the yield on the bond's earnings, the company is making money from the bond issuance. 

In other words, if a company can invest its profits in a bond at a higher interest rate than its interest rate, it can make good use of the bond. 

Municipalities traditionally issue bonds for all fixed asset expansion because they cannot pay for buildings and capital assets with income from operations. 

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Authored & Researched by Ahmed Makki | Linkedin

Edited by Colt DiGiovanni | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: