What are Bonds?
A bond is a security that denotes the debt owed by the issuer to the bondholders and he is liable to pay the coupon (an interest) on the same or repay the actual amount in the future and these are also negotiable and here interest can be paid monthly, quarterly, half-yearly or even annually.
Market Price of Bond
The market price of a bond is the present value of all expected future principal and interest payments of the bonds discounted at the bonds yield to maturity (rate of return). It is to be noted that the yield and price of the bond are inversely related so that when the market rate rises, prices of the bond will fall and vice-versa.
The success of a bond is measured depending on the yield which they offer. Yield is the annual percentage of return earned on a security.
The current yield of the bondCurrent Yield Of The BondThe current yield formula essentially calculates the yield on a bond based on the market price instead of face value. The current yield of bond= Annual coupon payment/current market price is computed as Annual Coupons / Current Bond Price.
For instance, if a bond was issued for $1,000 with an annual coupon of $100 but if it is selling in the market for $1,100, then the yield would be: 100/1100 = 9.09%
Types of Bonds
Some of the popular types of bonds are:
- Fixed-rate bonds have coupons remaining constant throughout the life of the bond.
- Floating Rate Notes are those having the coupon linked to the reference rate of interest, such as the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.. Since these are volatile in nature, they are classified as Floating. For e.g., the interest rate may be defined as LIBOR + 0.25% and does get re-calculated on a periodical basis.
- Corporate Bonds is a debt security issued by various Corporations and sold to various investors. The backing for such bonds depends on the payment ability of the company, which in turn is linked to future possible earnings of the company from its operations. These are the aspects looked in by the credit rating agencies before giving in their confirmation.
- Government Bonds is a bond issued by the National Government promising to make regular payments and repay the face value on maturity. The terms on which the government can market depends on the creditworthiness in the market.
- Zero-Coupon Bonds do not pay periodical interest. They are usually issued at a discount to the par value, making it attractive. This difference is then rolled up on maturity, and the full principal amount is paid on maturity. Such bonds can also be issued by financial institutions by stripping off the coupons from the principal amount.
- High Yield Bonds are those which are rated below investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments. by the credit rating authorities. Since these are lower grades, they are expected to offer larger yield and making them attractive. These are also termed as Junk Bonds.
- Convertible Bonds allow the holder to exchange a bond against a number of equity shares. These are considered as hybrid securitiesHybrid SecuritiesHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering. since they combine features of equity as well as debt.
- Inflation-indexed bonds are those in which the principal and the interest amount is linked to the inflation prevailing in the economy.
- Subordinated bonds have a lower priority than other bonds of the issuer at the time of liquidation. The risk is higher compared to Senior bonds, and once the creditors and senior bondholders are paid, the subordinated bondholders are prioritized. Comparatively, they have a lower credit rating, and some of the examples are bonds issued by banks, asset-backed securities, etc.
- Foreign Bonds are issued in the domestic market by a foreign entity in the currency of the domestic market as a means of raising capital. As most of the investors would be from the domestic market, it can prove to benefit as they will get an opportunity to include foreign exposure in their respective portfolios. Some of the instances of foreign bonds are:
- Bulldog Bond
- Samurai Bond
- Yankee BondYankee BondA Yankee bond is a bond issued by a foreign entity, such as a bank or financial institution, and traded in US dollar currency in America. The Securities Act of 1933 governs these bonds, which involve a lot of paperwork and are rated by credit rating firms like Moody's and S&P.
- Matilda Bond
Types of Risks
Bonds are subject to various types of risks, such as:
- Credit RiskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.
- Liquidity Risk
- Foreign Exchange Risk
- Inflation RiskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.
- Sovereign/Country Risk
- Volatility Risk
- Yield Curve Risk
Changes in the prices of the bond have an immediate impact on the portfolio of securities as it offers relatively stable returns. Additionally, the price of the Government bond is very sensitive as it will depict the economic stability of the respective country. The prices can also be impacted by the credit rating agencies upgrade or downgrade.
A number of bond indices exist for the management of portfolios and measuring performances such as:
Most of the indices are branches of other indices for measuring global bond portfolios or can be further subdivided for the management of customized portfolios depending on maturity or industry splits.
In financial terms, a bond is an instrument of debt from the bond issuer to the bondholder. It is security confirming debt, in which the issuer owes a debt to the holder and has an obligation for payment of the interest amount (coupon rate) at specified intervals or the making the entire principal amount at a later date on maturity. These interest amounts could be paid Annually, Semi-annually, or even monthly. The ownership of the bond is transferable in the secondary market, which makes it more liquid.
This has been a guide to what are bonds, the price of a bond, types of bonds, types of riks, and bond indices. You may also have a look at the following articles to learn more about fixed income –