What are Bonds?
In financial terms, a bond is an instrument of debt from the bond issuer to the bondholder. It is a 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.
Market Price of Bond
The market price of 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 yield and price of the bond are inversely related so that when market rate rises, prices of 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 bond 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 which 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 LIBOR. Since these are volatile in nature, they are classified as Floating. For e.g. the interest rate maybe 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 does 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 through stripping off the coupons from the principal amount.
- High Yield Bonds are those which are rated below investment grade by the credit rating authorities. Since these are lower grade, they are expected to offer larger yield and making them attractive. These are also termed as Junk Bonds.
- Convertible Bonds allows the holder to exchange a bond against a number of equity shares. These are considered as hybrid securities 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 is 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 beneficial as they will get an opportunity to include foreign exposure in their respective portfolio. Some of the instances of foreign bonds are:
- Bulldog Bond
- Samurai Bond
- Yankee Bond
- Matilda Bond
Types of Risks
Bonds are subject to various types of risks such as:
- Credit Risk
- Liquidity Risk
- Foreign Exchange Risk
- Inflation 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 of global bond portfolios or can be further subdivided for management of customised portfolios depending on maturity or industry splits.
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 –