What Is A Bond?
A bond is a type of debt security, which a corporation, government or other entity uses to borrow money. When a large company, like Microsoft, wants to borrow money, it will issue bonds, which are purchased by those who wish to invest. The issue and purchase of the bonds makes Microsoft a borrower and those who purchase the bonds lenders. Furthermore, purchasing a Microsoft bond makes the purchaser a bondholder and creditor of Microsoft. Sovereign entities, such as foreign governments, also borrow money by issuing bonds, and individuals and institutions lend those funds by purchasing the bonds. In the U.S., the federal government, states and municipal bodies will borrow funds by issuing bonds, which may go by another name. For example, only Treasury Securities with a 30-year maturity are labeled “bonds” by the U.S. government. Those with maturities of 2, 3, 5, 7, and 10 years are called “notes.” Although the stock market gets a lot of attention from the financial press, the bond market is more important, if size is any indication. In the U.S., the value of traded bonds is around $40 trillion, twice that of domestic stock markets.
Bonds and Loans
Since a bond is a type of debt, funds received when the bonds are sold must be repaid at some point by the entity that issued the bonds. In addition, as with debt in general, there is a price – periodic payments of interest – charged for the borrowed funds. Interest payments are calculated at a determined rate on the principal, i.e., the amount of the loan, and are usually made semi-annually. The interest payment on a bond is called a coupon. The name dates from a time before the digital age, when bonds would have coupons that the investor clipped off and mailed to the bond issuer in order to claim the interest payment. Interest payments are determined by the coupon rate. For example, a bond with a face value of $1,000 and an annual coupon rate of 6.875% will pay $68.75 every year. Since this payment remains unchanged from year to year, and it represents income to the bondholder, bonds are generally referred to as fixed-income instruments.
However, bonds differ from loans in one important way. While loans are private transactions between two parties, a lender, such as a bank and a borrower, bonds are marketable securities. With loans, the lender usually holds the loan until it is repaid. But a bond holder will be able to sell his bonds before they matures, if he so desires. This is an important feature, which we will examine in detail later.
Another difference between loans and bonds is the length of the term and the source of the funds. Generally, short-term financing will take the form of bank loans, although large reputable corporations also borrow in the money market. The money market is an umbrella term for a variety of short-term financial instruments (maturities of a year or less), such as bank accounts, commercial paper and Treasury bills. Bonds, however, are for longer-term financing that is provided by the financial markets rather than banks.
Those who invest in bonds, i.e., purchase bonds, receive a bond certificate as evidence that they have become bondholders. The bond certificate will be denominated in multiples of $1,000; that is, it will have a face value, like currency notes, of $1,000 or some multiple of $1,000 such as $5,000. An issue of bonds could be used to raise $500,000, for example, by selling 500 $1,000 bonds. Issues of bonds in which all the bonds mature at the same time, are called term bonds. When the bonds mature at different times, they are called serial bonds. For instance, a $1,000,000 issue of serial bonds may be structured so that $200,000 worth matures after 5 years, another $200,000 after 10 years, and so on, until the full principal is repaid.
The conditions that govern an issue of bonds can be found in a document called a bond indenture, which sets out the rights and obligations of bondholders. Among other things. a bond indenture will state the maturity date of the bonds, the interest rate, and interest payment dates.
Bond prices are stated in terms of a percentage of face value. For example, a bond issue quoted at 105½ means that a $1,000 bond costs $1,000 x 1.055 = $1,055. A bond selling at 100 is said to be selling at face value or par. One that sells above 100 is selling at a premium, while one selling below 100 is selling at a discount.
Bonds are traded through dealers and this results in two types of bond prices: asked prices and bid prices. Someone who wants to buy a bond would have to pay a dealer the asked price. If he were selling, the dealer would only buy at the bid price. The asked price is always above the bid price; the difference between the two is called the spread. The spread provides a way for the dealer to be remunerated for market making. Entities that provide market making take the risk and carry the cost of holding stocks of securities with the expectation that there will be future demand for those securities.
Bonds are Marketable Securities
Although bonds are essentially loans, they differ from traditional loans in that they are marketable securities. When a lender, such as a bank makes a traditional loan, it will typically retain ownership of the loan until the borrower pays it off. (To the lender, the loan is an asset; to the borrower, the loan is a liability) The bank will not usually sell or trade the loan. However, bonds can be traded in the bond market. Among other things, this allows the original lender to recoup his outlay of funds before the bond matures. This feature of bonds makes them attractive to investors and encourages investment, since bond investors know that at any time they may recover the money they have put out. Imagine how difficult it would be to sell 10-year or 20-year bonds, if bondholders would only get their money back after 10 or 20 years.
Since investors may be reluctant to purchase long-term bonds, why not issue only short-term bonds, 1-year or 2-year bonds, you may say. However, the term of a bond issue usually depends on the life cycle of the project the issue is financing. Some complex projects, such as the construction of a power plant, may take years to complete and become profitable. It makes sense to structure any bonds used to finance it on a similar long-term basis.
Funding long-term projects with short-term financing would be problematic for two reasons. First, it would entail issuing new bonds, every so often, to pay off the existing bonds, with all the uncertainty that would arise under such a scenario. Investors may find a project attractive now. Two years later, after it encounters a few snags, they may find it less so. Second, there’s the risk that the new bonds would have to offer a higher coupon rate, since the perceptions of the project’s risk may have changed. If investors believe the risk of the project has increased, they will demand a higher coupon rate on any new bonds. Being able to issue long-term bonds removes these uncertainties. Interest payments are fixed and the funds are available over the life of the project.
There are exceptions to the general practice of keeping loans on the books until they are paid off, one of which is the securitization of these loans. Loan securitization involves the creation of tradable securities that are backed by a pool of traditional loans. A bank will sell part of its loan portfolio to a Special Purpose Vehicle (SPV), which will then issue debt securities. The SPV pays the bank from the proceeds of the sale of the debt securities and then pays interest and principal to the holders of the debt securities from cash flows received on the original loans. These cash flows are derived from the monthly payments made on the loans.
Types of Bonds
Bonds can be characterised in many ways, by type of issuer, by the market in which the bonds are issued, by coupon rate, and by a variety of other factors. Since bonds are loans, the identity of the issuer (borrower) is a major determinant in assessing creditworthiness. Bonds issued by government and multilateral institutions are generally considered safer than those issued by private corporations are.
The three major rating agencies – Fitch, Moody’s and Standard & Poor’s – issue bond ratings according to their own proprietary scales. For example, Standard & Poor’s rating scale for long-term issuers has about a dozen classes ranging from AAA, the highest rating, to D, for default. The S&P ratings use combinations of letters to indicate rankings, as follows: AAA (extremely strong capacity to meet its financial commitments), AA, A, BBB (adequate capacity to meet its financial commitments), BB, B, CCC (dependent upon favorable conditions to meet its financial commitments), CC, R (under regulatory supervision), SD (selective default) and D (default). Thus, bonds can be rated by creditworthiness.
Bonds can also be classified according to coupon type. So far, our discussion of bonds has assumed that all bonds pay an unchanging coupon, every six or twelve months, over the life of the bonds and, upon maturity, pay the par value (face value) of the bond and the last coupon payment. Indeed, straight, plain vanilla or fixed-rate bonds do exactly that. However, some bonds pay no coupon at all. These zero-coupon bonds are issued at a discount to the face value and redeemed at face value. Some U.S. government securities – Treasury Bills, Zero-Coupon Bonds, etc – are zero-coupon bonds. For example, U.S. Treasury 1–year Bills, which are sold by auction, may go for 98.50, that is a $1,000 bill will be sold for $985.00. When the bill is redeemed a year later at $1,000, an investor would have earned a little more than 1.5%.
Yield-to-Maturity (YTM) on U.S. Treasury 1–year Bills = (1000 – 985)/985 = 1.522483%
Some bonds are neither fixed-rate or zero-coupon, for their coupon rates change in line with certain interest rate benchmarks. These floating-rate debt instruments or floaters may be tied to a U.S. T-bill rate or the SOFR (Secured Overnight Financing Rate) at a fixed percentage above the benchmark. Floaters tied to such short-term rates tend to adjust more quickly to changing market conditions. Some floaters – inverse floaters – operate inversely and their coupon payments will rise if short-term rates fall, and fall if short-term rates rise.