Bonds

Bonds are financial instruments issued by corporations or governments (called the issuer) to investors (called the bondholders) representing the amount of debt due to the bondholders by the issuer. Bonds typically make interest payments (called the coupon payments) after equal intervals (mostly semiannually) at a fixed or variable rate called the coupon rate and they have a fixed maturity date (longer than one year from the issue date) at which the issuer pays back the principal amount of the bond (called the face value or the par value) to the bondholder.

Bonds are the most popular debt-instruments issued by governments and established businesses to raise capital at a cost lower than the bank loans or other forms of debt financing. Each bond issue is governed by a contract called bond indenture which specifies the conditions and lists any covenants that the issuer must meet.

Types

Governments bonds are bonds issued by a federal (foreign or local) government. US government bonds are called treasury notes (when the maturity is more than one year but less than ten) and treasury bonds (when the maturity is more than 10 years). Despite the difference in terminology, they are both bonds. US treasury securities (T-bill, treasury notes and treasury bonds) are theoretically risk-free. UK government bonds are called gilts.

Where the bonds are issued by a state or local government, they are called municipal bonds (or munis for short). They are typically issued to finance an infrastructure project and the interest is paid out of the revenue of the project, in which case they are called revenue bonds. All municipal bonds other than the revenue bonds are called general-obligation bonds because the state’s obligation to pay back the loan is general and not limited to revenue of any project.

Corporate bonds are bonds issued by corporations. Their issue is regulated by the relevant corporate regulator such as the Securities & Exchange Commission in US. Corporations typically issue a document (called prospectus) outlining the purpose of the issue and offering an overview of its business and the issue is managed by investment bankers. Typically, corporations offer an asset such a plant or inventories as a collateral to be liquidated to pay back the bondholders in case of default by the issuer), in which case the bonds are called mortgage bonds. Where no collateral is offered against a bond, it is called a debenture.

While a standard bond pays periodic interest, there are bonds that do no pay any periodic coupon payments instead all their return comes from the difference in their initial issue price and final redemption value at maturity. Such bonds are called zero-coupon bonds (also called discount bonds or deep discount bonds). Also, standard bonds have a fixed maturity date but some bonds, called callable bonds, give the issuer the option to retire the bonds prior to maturity date; and some bonds, called putable bonds, give the bondholder the option to redeem their bonds prior to maturity. While most bonds have a fixed coupon rate, some bonds, called floating-rate bonds, have a coupon-rate linked to some other reference rate such a LIBOR. Coupon payments on some bonds, called inflation-protected bonds, is linked to some measure of inflation such as CPI such that the bondholder is protected against inflation. Treasury bonds that are indexed to inflation are called treasury-inflation protected securities (or TIPS). Convertible bonds are bonds that can be converted to the common stock of the corportion issuing them at the option of the bondholder.

Rating agencies such as Standard & Poor’s, Moody’s and Fitch rate government and corporate bonds which are indicative of the bond’s default risk. Bonds with a rating of BBB- or Baa3 are called investment-grade bonds and bonds that have a rating lower than BB or Ba are called junk bonds (also called high-yield bonds) because they have an elevated risk of default and hence higher yields.

Written by Obaidullah Jan, ACA, CFA and last modified on