Financial Instruments for Beginners: An Introduction to Bonds
WHAT IS A BOND?
A bond is an agreement between an investor and a company, government, or government agency that issues the bond. When investors buy a bond, they are loaning money to the issuer in exchange for interest and the return of principal at maturity. Bonds traditionally pay the investor a fixed interest periodically, hence they are fixed-income securities.
Unlike stocks, bonds don’t make the investor an owner of the bond issuer. Instead, the investor becomes a lender to the company or government.
HOW DOES BONDS WORK?
When an investor purchases a bond, they are “loaning” money (the initial amount called the principal) to the bond issuer, who is trying to raise money for a diverse number of reasons. For instance, for a company that is willing to expand its operations but doesn’t have enough funds for it, they may turn to the public for their financing by issuing bonds to raise the needed capital.
The Lifecycle of a Bond
1. The company issues a bond, also known as the bond origination.
2. The bond can then be purchased by investors
3. The investor receives regular interest payments from the issuer until the date of maturity. These periodic interest payments are called coupon payments. The amount of coupon payments is determined by the coupon rate, which is expressed as a percentage of the principal (initial amount).
4. When a bond matures, the issuer (company or govt.) repays the principal to the investor.
Example of a typical bond agreement:
· Company A issues a 10-year bond with a face value of $10,000 and a coupon rate of 5%.
· The investor agrees to buy the bond under the conditions that the company will pay $500 (5% of $10,000) each year over the 10-year period.
· At the end of the 10-year period, the company will repay the investor $10,000.
WHO ARE BONDHOLDERS?
Bondholders are investors who own bond and are considered creditors to the issuing organization. Bondholders can either decide to sell their bonds to other investors or receive interest payments by holding the bonds till maturity.
HOW ARE BONDS PRICED?
A bond’s price is equal to the present value of its expected future cashflows. For example, say a bond is purchased for $1,000 (present value), the bond has a par value of $1,000, a coupon rate of 5%, and 10 years to maturity. The bond will return $50 (5% of $1,000) per year. At the maturity date, the investor will be paid back the $1,000 par value. This means that the total expected future cash flow of the bond is $1,500 [($50 for 10 years) + $1,000].
If new bonds are issued with coupon rates of 7%, then the existing bond will return less than the newly issued bonds (the existing coupon of 5% is less than the new 7%). These new bonds will be more attractive to investors and demand for them will increase, causing older bonds’ prices to fall — the value of the existing bond drops but the expected future cash flow does not change.
The value of bonds has an inverse relationship with the prevailing interest rate in the economy: when interest rates rises, bond prices decreases and vice-versa.
COMMON TYPES OF BONDS
Different categories of bonds offer investors different choices; the four major types are:
1. Municipal Bonds: Municipal bonds (or “muni” bonds) are debt obligations issued by local or state agencies. These types of bonds are a way to raise money for infrastructure projects like the construction of a convention center, water treatment facility, etc. Generally, these bonds are not subject to federal income tax and in some cases, they may not be taxable to residents of the state they are issued in.
2. Government Bonds: Government bonds (also known as treasuries or sovereign bonds) are bonds issued by a national government to raise money and support government spending. Government bonds are usually low-risk investments because they are backed by the issuing government and therefore have lower default risk than other types of bonds. They are generally of 3 different types: Treasury bills (short-term debt which mature in less than 1 year), Treasury notes (medium-term debt, matures in 2, 3, 5, or 10 years), and Treasury bonds (long-term debt with maturity ranging between 10 to 30 years).
3. Corporate Bonds: When investors buy corporate bonds, they lend money to a company or corporate entity. Corporate bonds are not usually sold directly through the issuing company itself but through corporate agents (Trustees). Using a third party helps alleviate certain risks, offer valuable knowledge to investors, and help communicate with corporations. Categories of bonds under this types includes Senior secured bonds, Senior unsecured bonds, Subordinated bonds and Convertible bonds.
4. Agency Bonds: Agency bonds are issued by government agencies to finance public relations project. The yield on agency bonds are typically higher than on Treasuries but lower than for corporate bonds.
Bonds are debt instruments that avails the issuing party an avenue to raise substantial amounts for various projects, hence they are a good means of financing for entities. However, as with all financial instruments/assets, they carry their own type of risk, chief among being the credit risk.
By Eze Kenechukwu, for THE FINANCE HUB
