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Bond (finance)
From Wikipedia, the free encyclopedia
In finance, a bond is a debtsecurity, in which the authorized
issuer owes the holders a debtand, depending on the terms of the
bond, is obliged to pay interest (the coupon) and/or torepay the
principal at a later date, termedmaturity. It is a formal contract
to repay borrowedmoney with interest at fixed intervals.[1]
Thus a bond is like aloan: the issueris the borrower, the bond
holderis the lender, and thecoupon is the interest. Bonds provide
the borrower with external funds to finance long-terminvestments,
or, in the case of government bonds, to finance current
expenditure. Certificatesof deposit (CDs) orcommercial paperare
considered to bemoney market instruments and not
bonds.
Bonds and stocks are both securities, but the major difference
between the two is that stock-holders are the owners of the company
(i.e., they have an equity stake), whereas bond holdersare lenders
to the issuers. Another difference is that bonds usually have a
defined term, ormaturity, after which the bond is redeemed, whereas
stocks may be outstanding indefinitely.An exception is aconsol
bond, which is aperpetuity (i.e., bond with no maturity).
Contents
[hide]
1 Issuing bonds 2 Features of bonds 3 Types of bonds
o 3.1 Bonds issued in foreign currencies 4 Trading and valuing
bonds 5 Investing in bonds
o 5.1 Bond indices 6 See also 7 References
8 External links
[edit] Issuing bonds
Bonds are issued by public authorities, credit institutions,
companies and supranationalinstitutions in theprimary markets. The
most common process of issuing bonds is throughunderwriting. In
underwriting, one or more securities firms or banks, forming
asyndicate, buyan entire issue of bonds from an issuer and re-sell
them to investors. The security firm takesthe risk of being unable
to sell on the issue to end investors. However government bonds
areinstead typically auctioned.
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[edit] Features of bonds
The most important features of a bond are:
nominal, principal or face amount the amount on which the issuer
pays
interest, and which has to be repaid at the end. issue price the
price at which investors buy the bonds when they are
first issued, which will typically be approximately equal to the
nominalamount. The net proceeds that the issuer receives are thus
the issue price,less issuance fees.
maturity date the date on which the issuer has to repay the
nominalamount. As long as all payments have been made, the issuer
has no moreobligations to the bond holders after the maturity date.
The length of timeuntil the maturity date is often referred to as
the term or tenor or maturityof a bond. The maturity can be any
length of time, although debt securitieswith a term of less than
one year are generally designated money marketinstruments rather
than bonds. Most bonds have a term of up to thirtyyears. Some bonds
have been issued with maturities of up to one hundredyears, and
some even do not mature at all. In early 2005, a marketdeveloped in
euros for bonds with a maturity of fifty years. In the marketfor
U.S. Treasury securities, there are three groups of bond
maturities:
o short term (bills): maturities up to one year;o medium term
(notes): maturities between one and ten years;o long term (bonds):
maturities greater than ten years.
coupon the interest rate that the issuer pays to the bond
holders.Usually this rate is fixed throughout the life of the bond.
It can also varywith a money market index, such as LIBOR, or it can
be even more exotic.
The name coupon originates from the fact that in the past,
physical bonds
were issued which had coupons attached to them. On coupon dates
thebond holder would give the coupon to a bank in exchange for the
interestpayment.
Bond issued by the Dutch East India Company in 1623
The quality of the issue, which influences the probability that
thebondholders will receive the amounts promised, at the due dates.
This willdepend on a whole range of factors.
o Indentures and Covenants An indenture is a formal
debtagreement that establishes the terms of a bond issue,
whilecovenants are the clauses of such an agreement. Covenants
specify
the rights of bondholders and the duties of issuers, such as
actionsthat the issuer is obligated to perform or is prohibited
fromperforming. In the U.S., federal and state securities and
commercial
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laws apply to the enforcement of these agreements, which
areconstrued by courts as contracts between issuers and
bondholders.
The terms may be changed only with great difficulty while the
bondsare outstanding, with amendments to the governing
documentgenerally requiring approval by a majority (or
super-majority) voteof the bondholders.
o High yield bonds are bonds that are rated below investment
gradeby the credit rating agencies. As these bonds are more risky
thaninvestment grade bonds, investors expect to earn a higher
yield.
These bonds are also calledjunk bonds. coupon dates the dates on
which the issuer pays the coupon to the bond
holders. In the U.S. and also in the U.K. and Europe, most bonds
are semi-annual, which means that they pay a coupon every six
months.
Optionality: Occasionally a bond may contain an embedded option;
that is,it grants option-like features to the holder or the
issuer:
o Callability Some bonds give the issuer the right to repay the
bondbefore the maturity date on the call dates; see call option.
These
bonds are referred to as callable bonds. Most callable bonds
allowthe issuer to repay the bond at par. With some bonds, the
issuer hasto pay a premium, the so called call premium. This is
mainly thecase for high-yield bonds. These have very strict
covenants,restricting the issuer in its operations. To be free from
thesecovenants, the issuer can repay the bonds early, but only at a
highcost.
o Putability Some bonds give the holder the right to force the
issuerto repay the bond before the maturity date on the put dates;
see putoption. (Note: "Putable" denotes an embedded put
option;"Puttable" denotes that it may be putted.)
o call dates and put datesthe dates on which callable and
putablebonds can be redeemed early. There are four main
categories.
A Bermudan callable has several call dates, usually
coincidingwith coupon dates.
A European callable has only one call date. This is a
specialcase of a Bermudan callable.
An American callable can be called at any time until thematurity
date.
A death put is an optional redemption feature on a
debtinstrument allowing the beneficiary of the estate of
thedeceased to put (sell) the bond (back to the issuer) in theevent
of the beneficiary's death or legal incapacitation. Also
known as a "survivor's option". sinking fund provision of the
corporate bond indenture requires a certain
portion of the issue to be retired periodically. The entire bond
issue can beliquidated by the maturity date. If that is not the
case, then the remainderis called balloon maturity. Issuers may
either pay to trustees, which in turncall randomly selected bonds
in the issue, or, alternatively, purchasebonds in open market, then
return them to trustees.
convertible bond lets a bondholder exchange a bond to a number
of sharesof the issuer's common stock.
exchangeable bond allows for exchange to shares of a corporation
otherthan the issuer.
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[edit] Types of bonds
Bond certificate for the state ofSouth Carolina issued in 1873
under the state's
Consolidation Act.
Fixed rate bonds have a coupon that remains constant throughout
the life
of the bond.
Floating rate notes (FRNs) have a coupon that is linked to an
index.Common indices include: money market indices, such as LIBOR
or Euribor,and CPI (the Consumer Price Index). Coupon examples:
three month USDLIBOR + 0.20%, or twelve month CPI + 1.50%. FRN
coupons resetperiodically, typically every one or three months. In
theory, any Indexcould be used as the basis for the coupon of an
FRN, so long as the issuerand the buyer can agree to terms.
Zero coupon bonds don't pay any interest. They are issued at a
substantial
discount to par value. The bond holder receives the full
principal amounton the redemption date. An example of zero coupon
bonds are Series Esavings bonds issued by the U.S. government. Zero
coupon bonds may becreated from fixed rate bonds by a financial
institutions separating"stripping off" the coupons from the
principal. In other words, theseparated coupons and the final
principal payment of the bond are allowedto trade independently.
See IO (Interest Only) and PO (Principal Only).
Inflation linked bonds, in which the principal amount and the
interestpayments are indexed to inflation. The interest rate is
normally lower thanfor fixed rate bonds with a comparable maturity
(this position brieflyreversed itself for short-term UK bonds in
December 2008). However, as
the principal amount grows, the payments increase with
inflation. Thegovernment of the United Kingdom was the first to
issue inflation linkedGilts in the 1980s.Treasury
Inflation-Protected Securities (TIPS) and I-bonds are examples of
inflation linked bonds issued by the U.S.government.
Other indexed bonds, for example equity-linked notes and bonds
indexedon a business indicator (income, added value) or on a
country's GDP.
Asset-backed securities are bonds whose interest and principal
paymentsare backed by underlying cash flows from other assets.
Examples of asset-
backed securities are mortgage-backed securities (MBS's),
collateralizedmortgage obligations (CMOs) and collateralized debt
obligations (CDOs).
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Subordinated bonds are those that have a lower priority than
other bondsof the issuer in case ofliquidation. In case of
bankruptcy, there is ahierarchy of creditors. First the liquidator
is paid, then government taxes,etc. The first bond holders in line
to be paid are those holding what iscalled senior bonds. After they
have been paid, the subordinated bondholders are paid. As a result,
the risk is higher. Therefore, subordinatedbonds usually have a
lower credit rating than senior bonds. The mainexamples of
subordinated bonds can be found in bonds issued by banks,and
asset-backed securities. The latter are often issued in tranches.
Thesenior tranches get paid back first, the subordinated tranches
later.
Perpetual bonds are also often called perpetuities. They have no
maturitydate. The most famous of these are the UK Consols, which
are also knownas Treasury Annuities or Undated Treasuries. Some of
these were issuedback in 1888 and still trade today, although the
amounts are nowinsignificant. Some ultra long-term bonds (sometimes
a bond can lastcenturies: West Shore Railroad issued a bond which
matures in 2361 (i.e.
24th century)) are virtually perpetuities from a financial point
of view, withthe current value of principal near zero.
Bearer bond is an official certificate issued without a named
holder. Inother words, the person who has the paper certificate can
claim the valueof the bond. Often they are registered by a number
to preventcounterfeiting, but may be traded like cash. Bearer bonds
are very riskybecause they can be lost or stolen. Especially after
federal income taxbegan in the United States, bearer bonds were
seen as an opportunity toconceal income or assets.[2] U.S.
corporations stopped issuing bearer bondsin the 1960s, the U.S.
Treasury stopped in 1982, and state and local tax-exempt bearer
bonds were prohibited in 1983.[3]
Registered bond is a bond whose ownership (and any
subsequentpurchaser) is recorded by the issuer, or by a transfer
agent. It is thealternative to a Bearer bond. Interest payments,
and the principal uponmaturity, are sent to the registered
owner.
Municipal bond is a bond issued by a state, U.S. Territory,
city, localgovernment, or their agencies. Interest income received
by holders ofmunicipal bonds is often exempt from the federal
income tax and from theincome tax of the state in which they are
issued, although municipal bondsissued for certain purposes may not
be tax exempt.
Book-entry bond is a bond that does not have a paper
certificate. Asphysically processing paper bonds and interest
coupons became moreexpensive, issuers (and banks that used to
collect coupon interest fordepositors) have tried to discourage
their use. Some book-entry bondissues do not offer the option of a
paper certificate, even to investors whoprefer them.[4]
Lottery bond is a bond issued by a state, usually a European
state. Interestis paid like a traditional fixed rate bond, but the
issuer will redeemrandomly selected individual bonds within the
issue according to a
schedule. Some of these redemptions will be for a higher value
than theface value of the bond.
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War bond is a bond issued by a country to fund a war.
Serial bond is a bond that matures in installments over a period
of time. Ineffect, a $100,000, 5-year serial bond would mature in a
$20,000 annuityover a 5-year interval.
Revenue bond is a special type of municipal bond distinguished
by itsguarantee of repayment solely from revenues generated by a
specifiedrevenue-generating entity associated with the purpose of
the bonds.Revenue bonds are typically "non-recourse," meaning that
in the event ofdefault, the bond holder has no recourse to other
governmental assets orrevenues.
[edit] Bonds issued in foreign currencies
Some companies, banks, governments, and other sovereign entities
may decide to issue bonds
in foreign currencies as it may appear to be more stable and
predictable than their domesticcurrency. Issuing bonds denominated
in foreign currencies also gives issuers the ability toaccess
investment capital available in foreign markets. The proceeds from
the issuance ofthese bonds can be used by companies to break into
foreign markets, or can be converted intothe issuing company's
local currency to be used on existing operations. Foreign issuer
bondscan also be used to hedge foreign exchange rate risk. Some of
these bonds are called by theirnicknames, such as the "samurai
bond."
Eurodollar bond, a U.S. dollar-denominated bond issued by a
non-U.S.entity outside the U.S[5]
Kangaroo bond, an Australian dollar-denominated bond issued by a
non-
Australian entity in the Australian market Maple bond, a
Canadian Dollar-denominated bond issued by a non-
Canadian entity in the Canadian market Samurai bond, a Japanese
Yen-denominated bond issued by a non-
Japanese entity in the Japanese market Shibosai Bond is a
private placement bond in Japanese market with
distribution limited to institutions and banks. Yankee bond, a
US Dollar-denominated bond issued by a non-US entity in
the US market Shogun bond, a non-yen-denominated bond issued in
Japan by a non-
Japanese institution or government[6]
Bulldog bond, a pound sterling-denominated bond issued in London
by a
foreign institution or government Matrioshka Bond, a Russian
rouble-denominated bond issued in the
Russian Federation by non-Russian entities. The name derives
from thefamous Russian wooden dolls, Matrioshka, popular among
foreign visitorsto Russia
Arirang bond, a Korean won-denominated bond issued by a
non-Koreanentity in the Korean market[7]
Kimchi bond, a non-Korean won-denominated bond issued by a
non-Koreanentity in the Korean market.[8]
Formosa bond, a non-New Taiwan Dollar-denominated bond issued by
anon-Taiwan entity in the Taiwan market[9]
Panda bond, a Chinese renminbi-denominated bond issued by a
non-Chinaentity in the People's Republic of China market[10]
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State of Israel bond, a bond denominated in multiple currencies
issued bythe State of Israel through the Development Corporation of
Israel.
[edit] Trading and valuing bondsSee also: Bond valuation
The interest rate that the issuer of a bond must pay is
influenced by a variety of factors, suchas current market interest
rates, the length of the term and the creditworthiness of the
issuer.
These factors are likely to change over time, so the market
price of a bond will vary after it isissued. This price is
expressed as a percentage of nominal value. Bonds are not
necessarilyissued at par (100% of face value, corresponding to a
price of 100), but bond prices convergeto par when they approach
maturity (if the market expects the maturity payment to be made
infull and on time) as this is the price the issuer will pay to
redeem the bond. At other times,
prices can be above par (bond is priced at greater than 100),
which is called trading at apremium, or below par (bond is priced
at less than 100), which is called trading at a discount.Most
government bonds are denominated in units of $1000, if in the
United States, or in unitsof 100, if in the United Kingdom. Hence,
a deep discount US bond, selling at a price of75.26, indicates a
selling price of $752.60 per bond sold. (Often, in the US, bond
prices arequoted in points and thirty-seconds of a point, rather
than in decimal form.) Some short-term
bonds, such as the U.S.Treasury Bill, are always issued at a
discount, and pay par amount atmaturity rather than paying coupons.
This is called a discount bond.
The market price of a bond is thepresent value of all expected
future interest and principalpayments of the bond discounted at the
bond'sredemption yield, orrate of return. Thatrelationship defines
the redemption yield on the bond, which represents the current
market
interest rate for bonds with similar characteristics. The yield
and price of a bond are inverselyrelated so that when market
interest rates rise, bond prices fall and vice versa. Thus
theredemption yield could be considered to be made up of two parts:
the current yield (see
below) and the expected capital gain or loss: roughly the
currentyield plus the capital gain(negative for loss) per year
until redemption.
Themarket price of a bond may include the accrued interest since
the last coupon date. (Somebond markets include accrued interest in
the trading price and others add it on explicitly aftertrading.)
The price including accrued interest is known as the "full" or
"dirty price".(See alsoAccrual bond.) The price excluding accrued
interest is known as the "flat" or
"clean price".
The interest rate adjusted for (divided by) the current price of
the bond is called thecurrentyield (this is the nominal
yieldmultiplied by the par value and divided by the price).
The relationship between yield and maturity for otherwise
identical bonds is called a
yield curve.
Bonds markets, unlike stock or share markets, often do not have
a centralized exchange ortrading system. Rather, in most
developedbond marketssuch as the U.S., Japan and westernEurope,
bonds trade in decentralized, dealer-based over-the-countermarkets.
In such amarket, market liquidityis provided by dealers and other
market participants committing risk
capital to trading activity. In the bond market, when an
investor buys or sells a bond, thecounterparty to the trade is
almost always a bank or securities firm acting as a dealer. In
some
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cases, when a dealer buys a bond from an investor, the dealer
carries the bond "in inventory."The dealer's position is then
subject to risks of price fluctuation. In other cases, the
dealerimmediately resells the bond to another investor.
Bond markets can also differ from stock markets in that, in some
markets, investors
sometimes do not pay brokerage commissions to dealers with whom
they buy or sell bonds.Rather, the dealers earn revenue by means of
the spread, or difference, between the price atwhich the dealer
buys a bond from one investor -- the "bid" price -- and the price
at which heor she sells the same bond to another investor--the
"ask" or "offer" price. Thebid/offer spreadrepresents the total
transaction cost associated with transferring a bond from one
investor toanother.
[edit] Investing in bonds
Bonds are bought and traded mostly by institutions likepension
funds, insurance companiesandbanks. Most individuals who want to
own bonds do so throughbond funds. Still, in theU.S., nearly 10% of
all bonds outstanding are held directly by households.
Sometimes, bond markets rise (while yields fall) when stock
markets fall. More relevantly,the volatility of bonds (especially
short and medium dated bonds) is lower than that of shares.Thus
bonds are generally viewed as safer investments than stocks, but
this perception is only
partially correct. Bonds do suffer from less day-to-day
volatility than stocks, and bonds'interest payments are often
higher than the general level ofdividend payments. Bonds areliquid
it is fairly easy to sell one's bond investments, though not nearly
as easy as it is tosell stocks and the comparative certainty of a
fixed interest payment twice per year isattractive. Bondholders
also enjoy a measure of legal protection: under the law of most
countries, if a company goesbankrupt, its bondholders will often
receive some money back(therecovery amount), whereas the company's
stock often ends up valueless. However, bondscan also be risky:
Fixed rate bonds are subject to interest rate risk, meaning that
theirmarket prices will decrease in value when the generally
prevailing interestrates rise. Since the payments are fixed, a
decrease in the market price ofthe bond means an increase in its
yield. When the market interest raterises, the market price of
bonds will fall, reflecting investors' ability to get ahigher
interest rate on their money elsewhere perhaps by purchasing anewly
issued bond that already features the newly higher interest
rate.Note that this drop in the bond's market price does not affect
the interestpayments to the bondholder at all, so long-term
investors who want aspecific amount at the maturity date need not
worry about price swings intheir bonds and do not suffer from
interest rate risk.
Price changes in a bond will also immediately affect mutual
funds that hold these bonds. Ifthe value of the bonds held in a
tradingportfoliohas fallen over the day, the value of the
portfolio will also have fallen. This can be damaging for
professional investors such as banks,insurance companies, pension
funds and asset managers (irrespective of whether the value
isimmediately "marked to market" or not). If there is any chance a
holder of individual bondsmay need to sell his bonds and "cash
out", interest rate risk could become a real problem.(Conversely,
bonds' market prices would increase if the prevailing interest rate
were to drop,as it did from 2001 through 2003.) One way to quantify
the interest rate risk on a bond is interms of its duration.
Efforts to control this risk are called immunization orhedging.
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Bond prices can become volatile depending on the credit rating
of theissuer - for instance if the credit rating agencies like
Standard & Poor's andMoody's upgrade or downgrade the credit
rating of the issuer. Adowngrade will cause the market price of the
bond to fall. As with interestrate risk, this risk does not affect
the bond's interest payments (providedthe issuer does not actually
default), but puts at risk the market price,which affects mutual
funds holding these bonds, and holders of individualbonds who may
have to sell them.
A company's bondholders may lose much or all their money if
thecompany goes bankrupt. Under the laws of many countries
(including theUnited States and Canada), bondholders are in line to
receive the proceedsof the sale of the assets of a liquidated
company ahead of some othercreditors. Bank lenders, deposit holders
(in the case of a deposit takinginstitution such as a bank) and
trade creditors may take precedence.
There is no guarantee of how much money will remain to repay
bondholders. As an example,
after an accounting scandal and aChapter 11 bankruptcy at the
giant telecommunicationscompany Worldcom, in 2004 its bondholders
ended up being paid 35.7 cents on the dollar. Ina bankruptcy
involving reorganization or recapitalization, as opposed to
liquidation,
bondholders may end up having the value of their bonds reduced,
often through an exchangefor a smaller number of newly issued
bonds.
Some bonds are callable, meaning that even though the company
hasagreed to make payments plus interest towards the debt for a
certainperiod of time, the company can choose to pay off the bond
early. Thiscreates reinvestment risk, meaning the investor is
forced to find a newplace for his money, and the investor might not
be able to find as good a
deal, especially because this usually happens when interest
rates arefalling.
[edit] Bond indices
See also: Bond market index
A number of bond indices exist for the purposes of managing
portfolios and measuringperformance, similar to the S&P 500
orRussell Indexes forstocks. The most commonAmerican benchmarks are
the (ex) Lehman Aggregate, Citigroup BIG and Merrill LynchDomestic
Master. Most indices are parts of families of broader indices that
can be used tomeasure global bond portfolios, or may be further
subdivided by maturity and/or sector formanaging specialized
portfolios.
[edit] See also
Bond market Bond fund Bond market index Brady Bonds Eurobond
Bond credit rating Collective action clause Criticism of debt
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Debenture Deferred financing costs Fixed income Immunization
(finance) List of accounting topics List of economics topics List
of finance topics
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![Bonds Edited Gj Testimony[1]](https://img.pdfslide.us/doc/110x75/577d2c5b1a28ab4e1eabfcd6/bonds-edited-gj-testimony1.jpg)
