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What are bonds?

Learn what bonds are

Managers must be aware of not just short-term but also long-term financing options available to them. Depending on their unique situation, they should be able to opt for the one that is best for them.

Bonds are part of an asset class that is known as a fixed-income security. They are considered a ‘defensive asset’, one that will provide a stable source of income, often included in investment portfolios to negate any riskier assets that might exist in the portfolio (e.g. commodities, equities, etc.). Essentially, bonds are an instrument that will make a series of interest payments over time in fixed amounts, in order to repay a certain amount at the time of its maturity (specified date).

Entities issuing bonds

You might have heard of bonds as a mechanism that governments use to increase or decrease money supply (either buying or selling bonds). However, bonds usage goes far beyond governments and they can be used by corporations and municipalities when they need extra capital. In fact, the global bond market is worth US$100 trillion as of end of year 2017 [1], compared to the global equities market of major exchanges across the world valued at $69 trillion [2].

There are several entities that can issue bonds:

  • Quasi-public entities (e.g. those that are in the private sector but have a government mandate to provide a given service, often starting as government agencies turned private over time, such as Telstra in Australia or Fannie Mae in USA) issue bonds.
  • National governments will offer treasury bonds.
  • Non-sovereign governments, such as state governments or cities, can also offer bonds.
  • Corporations, such as Apple, offer bonds.
  • International worldwide entities, such as the World Bank or the IMF, offer bonds.

Key features

There are some key features that define a bond:

  1. Par value. This is the amount of money that you (the holder) will get back once a bond matures. It can also be referred to as the face value, maturity value, redemption value, or principal value.

    a. Bonds can have a par value of any amount, and bonds are quoted as a percentage of their par. A US$10,000 bond quoted at 96 is selling for $9,600.

    b. Bonds that are selling for more than its par value are trading at a premium.

    c. Bonds that are selling less than its par value are trading at a discount.

    d. Bonds that are selling for exactly par value are trading at par.

  2. Bond maturity. This is the final payment date of the loan that is to be repaid.

    a. When a bond is issued, the time remaining until maturity (e.g. the final payment date) is referred to as the term-to-maturity.

    b. Bonds that have no maturity date are called perpetual bonds.

    c. Bonds that have a maturity date of less than a year are called money market bonds.

    d. Bonds with a maturity date of over a year are capital market bonds.

  3. Coupon interest rate. This is the amount of interest the holder of the bond will receive per payment; expressed as a percentage of par value.

    a. Interest rates will be fixed throughout the bond’s life.

    b. There are some bonds that do not have interest rates, and are called zero-coupon bonds.

  4. Call provisions. Bonds that allow the issuer to redeem the bond before it is mature are called callable bonds.

    a. An issuer might recall a bond when interest rates go down before the call date, in order to refinance debt.

  5. Yield. This is the rate of return received from investing in the bond. It will be referred to as the current yield, or yield to maturity or redemption yield; the yield includes the payment principal and interest.
  6. The currency of the bond. This is clearly an important feature of the bond, and bonds can be issued in various currencies.

    a. Dual-currency bonds will make interest payments in one currency and principal repayment in another.

    b. Currency option bond gives the purchaser an option of which currency they want to receive their payments in.

Essentially, bonds are priced based on the probability that they will fail to make their payments: the lower the probability of default, the lower the yield; the higher the probability of default (e.g. lower credit rating), the higher the yield. Investors want to be rewarded for taking risk.

It is important to note that when the interest rate increases, the value of bonds decrease due to the fact that a bond’s repayment cash flow decreases when a higher interest rate is used. Similarly, when interest rates go down, bond prices will rise.

Now that you know the correlation between interest rate and bond, read this interesting document from the U.S. Securities and Exchange Commission, shedding some light on this relation a bit more:

Read: (Optional)How do interest rates affect bond prices? [3]

This article showcases examples of the phenomenon:

Read: (Optional)Why do bond prices go down when interest rates rise? [4]

References

1. Sifma fact book [Internet]. Sifma. Available from: https://www.sifma.org/wp-content/uploads/2017/08/US-Fact-Book-2018-SIFMA.pdf

2. Desjardins, J. All of the world’s stock exchanges by size [Internet]. Visual Capitalist; 2016 Feb 17. Available from: https://www.visualcapitalist.com/all-of-the-worlds-stock-exchanges-by-size/

3. How do interest rates affect bond prices? [Online]. SEC, Officer of Investor Education & Advocacy. Available from: https://www.sec.gov/files/ib_interestraterisk.pdf

4. Luthi, B. Why do bond prices go down when interest rates rise? [Internet]. The Balance; 2020 Jul 28. Available from: https://www.thebalance.com/why-do-bond-prices-go-down-when-interest-rates-rise-2388565

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Financial Analysis for Business Decisions: Cash Flow Management

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