A majority of governments and corporations would not have succeeded like they have done today without one form of borrowing or the other. One of the common methods of borrowing that these entities engage in is usually the use of bonds. In the case of governments, for instance, all the tiers of governments at any given time have projects to complete.
Governments are tasked with developments like building roads, schools, dams, and a lot more for the public. All of these projects need funds and bonds come in as an excellent strategy of raising money. The same story can be told about corporations.
Corporations borrow for business expansions, research, acquiring experts and developments or venturing into new profitable investments. Since some of the projects are capital intensive, banks may lack enough funds to support these corporations. Thus, they turn to bonds. Bonds are known to create avenues for individuals to invest in the companies, in turn, assuming the role of lenders.
A bond is a fixed income tool used by corporations or governments to get loans from individual lenders. A bond is normally between two entities, a borrower and a lender. The bond owners are known as issuers, debt holders or creditors.
Each of the bonds that are floated has important details for authenticity which include expiration date and the agreement of interest rate between the lender and the borrower. The expiration date is the day when the loan must be repaid to the lender.
Most of the bonds share similar characteristics like:
The Coupon Rate
This characteristic is connected to the interest rate the bond issuer must pay depending on the bond’s face value. In most cases, it is denoted as a percentage. For example, when a 4% coupon rate is attached to a bond, bondholders expect $40 annually, supposing the face value is $1000. That amount is acquired by multiplying the coupon rate with the face value of $1000.
This is known as the amount that a bond is expected to amount to when it matures. All of the involved calculations on interest rates also find their basis here. For instance, if the premium attached to a bond is $2,090 and an investor bought it at that price then it later falls to $1,980 which another investor bought it because of the discount.
When the bond’s maturity period ends, the same face value of $2,000 will be paid to the two investors.
These are the set dates when the lender expects interest payments from the company of government. The payments do not have any particular interval although the standard is considered to be semiannual.
The Issue Price
It is described as the price tag of a bond for sale.
The bond is considered mature on this date and its face value must be paid to the bondholder by the bond issuer.
Here are the descriptions of the primary categories of bonds.
US Treasury Bonds
These bonds originate from the Federal government to help the country’s project development and they are credit-risk free. Nevertheless, they do not amount to much in terms of their yield.
Additionally, they have their strengths which are evident during economic downturns. During these times, they are known to fare better than the higher-yielding bonds and their interest enjoys state income tax exemption.
These bonds are issued by governmental bodies, for instance, the US Treasury. The Treasury is known to publish various bonds including Notes, Bills and Bonds. Bills mature within a year; Notes have a maturity lifespan of 1-10 years while Bonds mature from 10 years and above.
These are sold to companies to fund one project or another. Most companies issue bonds to raise capital using any of these two corporate bonds below:
- Investment-grade corporate bonds – Companies with a valid and verifiable high-profit record issue these bonds. Thus, they are rated at least triple-B from credible rating authorities including Moody’s Investors Service and Standard & Poor’s.
- High-yield corporate bonds – the bonds that come from the companies in this category have ratings that are lesser than triple-B since the companies involved have weak balance sheets. They are also prone to default with the prices of the bonds in this category reflecting the performance of the company.
They are also known as munis and their origin is traced in the US States and local governments. Their interest is not subjected to any form of tax and they are not available to just anyone. These bonds exist in two categories including the high-yield and investment-grade bonds.
As a result of the taxes that are imposed on taxable yields, their returns are considerably higher than those of munis as a form of compensation to investors.
These bonds come from federal agencies like the Federal Home Loan Mortgage Corp. (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (Ginnie Mae). Any interest earned by these bonds is taxable by the state and federal governments and they are characterized by minimal credit risk.
Furthermore, the yields acquired from agency bonds exceed that of Treasury since they are not considered full-faith-and-credit obligations of the United States government.
They are different types of securities with several of them being dollar-denominated. Averagely, these bonds are known to be denominated by foreign currencies.
Principal and interest payments with foreign-currency-denominated bonds are well-designed using a foreign currency. The exchange rate is used to determine their worth in dollars. Thus, the exchange rate has an upper hand more than the interest rates in determining the bonds’ general performance.
Types of Bonds
Investors have a wide range of bonds that they can choose from to suit their investment needs. To differentiate between them, one can check their interest rate or type, coupon payments, and several other characteristics.
The bonds that fall within this category can be readily switched into stocks according to the desire of the bondholder. That can be done through an inlaid option that enables the holder the right to change the nature of their securities. For example, a cash-strapped company about to manage and invest in a $1 million project can get funds by selling 12% coupon bonds with ten years of maturity.
Nevertheless, in the case that an investor is interested in bonds with an 8% coupon with the capability of converting them into stocks during the high yield period, the company can be persuaded into issuing such bonds instead.
It is also known as accrual bond. It features long maturity dates with an extreme discount price but the bondholders are not entitled to coupon payments. Its full value is paid upon maturity. Furthermore, this bond type is more unstable in price when compared to the coupon bonds. They are issued by the state and local government, corporations and the United States Treasury.
Companies employ the bond since it has inbuilt benefits that enable the company issued bonds to be recalled even before it reaches maturity. Thus, a company may create a $1 million investment bond to have a 10-year maturity period with a coupon of 10%. The company can recall the bonds after selling them to investors.
Various factors may influence this action like an improvement in the credit rating of the company or a decline in the rate of interest. These economic characteristics may enable the company to sell new bonds for a reduced coupon rate of maybe 8%. Thus, the previous bonds are rendered invalid and the holders are forced to take back their principal.
Once the company recalls previous bonds, it may proceed to issue fresh bonds at a coupon rate lower than before. Callable bonds benefit the company more than the investor since the company may go back on its agreement whenever it feels like doing that as long as it favours its interest.
Therefore, callable bonds are perceived to be less valuable compared to the non-callable bonds with the same coupon rate, maturity, and credit rating.
This is almost the exact reverse of the callable bonds in which the investors have the power to return the bond that they had purchased earlier from a company as they deem fit. As long as the investor feels the need to sell, it does not matter whether the bond is mature or not and the company is obligated to repurchase.
Investors go for this bond since it works in their best interest. For instance, if the bondholder thinks that the investment is no longer profitable and safe due to a decline in the bond value or a possible rise in the interest rate, the investor is entitled to return the bond to the issuing company to take back his principal.
Puttable bonds are usually more valuable than non-puttable bonds since bondholders find it to be a better investment.
Not all of these bonds mature at the same time. Some of them have a maturity limit of 1 year or less while others can exceed ten years. They are also significantly influenced by credit risks, inflation, and interest rates.
Whenever there is an increase in the rate of interest, the bond prices plummet. Nevertheless, in the case that a bond is not held to term, the bondholders run the risk of receiving less than it was bought. But sometimes, it may be worth more due to favorable market conditions.