Bonds

Bonds, a fixed-income instrument, are used by governments or companies to raise money by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period. From an investor’s viewpoint, bonds provide two potential benefits when they are part of an investment portfolio. They give an income stream and protect from the volatility seen by owning stocks.

Learning Outcomes

At the end of the course, you will be able to understand the following:

• What is a Bond?
• Bonds Market.
• Features of a Bond.
• Benefits of Bond Investing.
• Different Types of Bonds.
• Risks in Bonds.
• Buying and Selling Bonds.

What is a Bond?

Bonds are a means of financing in which a company borrows money by selling bond securities to investors. The bonds represent a loan to the issuing company. The company promises to pay the investor a specific interest every period by selling the bond until the bond matures.

At maturity, the company promises to pay the investor the face amount of the bond. The interest that will be paid each period, the face (or maturity) value and the maturity date are all printed on the face of the bond itself.

Investors purchase bonds because the bonds pay some interest to the purchaser, and additionally, the face amount of the bond will be paid at the bond maturity in the future.

Bonds Market

The bond markets are tapped or used by predominantly high-quality borrowers (investment grade) to raise money. Borrowers include governments, banks, other financial institutions, and companies (corporates). Increasingly, lower-rated (non-investment grade) companies issuing high-yield or ‘junk’ bonds participate in the market.

Borrowers access the debt capital markets for a variety of reasons:

• to reduce their cost of debt by cutting out the margin taken by banks (disintermediation),
• to diversify sources of finance and avoid reliance on bank finance, particularly as banks
  may be unwilling or unable to lend,
• less onerous terms (covenants) compared to bank finance,
• to achieve maturities longer than those typically offered by banks.

Investors include banks, insurance companies, pension funds, hedge funds, private individuals, and even, to a lesser degree, companies. Governments (via the central banks) issue and invest in bonds to influence the amount of money in circulation.

Given the importance of this market as a source of funding to the treasurer, this reading covers the key features of bonds and major bond markets before considering the issuance process and how and why bonds may be valued.

Features of a Bond

A bond will have a par value – its stated amount (face value), a stated interest rate, maturity date, and information about when interest is paid. The maturity date is the date on which the issuer will “retire” the bond by paying the face amount of the bond to the bondholder. Below is an example of basic bond information.

Example

Par (Face) Value – INR 1,000 Interest Rate – 8%
Issue Date – January 1, 2023
Maturity Date – December 31, 2030
Interest – paid semi-annually, June 30 and December 31.

From this information, we can determine all the amounts the issuer will pay to the bond buyer over the bond’s life. In addition, there are two cash flows that the bond issuer will deliver to the buyer: the repayment of the principal and regular interest payments.

Par (Face) Value

On the bond’s maturity date, the issuer will pay the face amount of the bond (INR 1,000 in this case) to the bondholder. This means that on December 31, 2030 (the maturity date), not only will the owner of the bond receive the semi-annual INR 40 interest payment for the period from July 1 through December 31 of that year, but the bondholder will also receive the INR 1,000 repayment of the face value of the bond.

Interest

The interest rate to be paid on the bond is sometimes called the coupon rate. That term originated with bearer bonds issued coupons for each scheduled interest payment.

The interest amount paid every June 30 and December 31 is calculated as the bond’s par (face) value multiplied by the stated annual interest rate and divided by 2.

For interest in this bond example, the bond issuer will pay INR 40 in cash as an interest to the bond purchaser every June 30 and December 31, beginning June 30, 2010, until December 31, 2020. The money received each period over the bond’s life is the same because it is calculated from the information on the bond itself.

Interest is generally paid semi-annually (twice a year) on bonds.

Selling Price of the Bond

The selling price of any bond is calculated by determining the present value of all of the future cash flows of the bond (each of the interest payments and the repayment of the face amount at maturity). This present value calculation (discounting) uses the market interest rate for other bonds with similar characteristics (same maturity, default risk, terms, and conditions, etc.).

This market rate is used because this is the rate of other investment alternatives with similar risk characteristics currently available. Therefore it is the minimum return that an investor would require. The company must sell the bonds at a price that will enable the investors to earn the return they seek.

Using the market rate of interest to calculate the selling price, the company assures that an investor who purchases the bond will receive a return equal to the market rate for investments of that risk level.

Discount or Premium on the Bond

Whenever the market interest rate is different from the rate stated on the bond itself, the selling price will be further from the face amount of the bond. This difference between the bond’s selling price and face amount is called a discount or premium.

If the selling price is less than the face value, it is said that the bond is selling at a discount. This situation arises when the market interest rate is higher than the interest rate stated on the bond. If the bond were sold at its face value, nobody would buy it because they could receive a higher return from another bond in the marketplace. By reducing the bond’s selling price (but not the amount of interest paid each period), the effective interest rate of the bond becomes equal to the market interest rate.

In a situation where the market interest rate is lower than the stated interest rate on the bond, the bond will be sold at a price above its face value. This higher sales price of the bond (but with the same interest payment made each period) makes the bond’s effective rate equal to the bond’s market rate. This is called a premium.

Since market interest rates are constantly changing but the interest amount paid by the bond does not change over its life, the market price of an individual bond will continually change, and previously issued bonds that are in the market bonds will most likely sell at either a discount or premium.

As with other loans, a bond is represented by a contract between the issuer (borrower) and the bondholders (lenders). The legal agreement is called the indenture, containing all the contract terms and conditions, including the interest rate, stated value, payment dates, maturity date, etc. In addition, the contract will likely include additional provisions relating to the bonds’ characteristics, the bondholders’ rights, or the issuer’s rights. These provisions include:

Restrictive Covenants

Restrictive covenants limit a company’s actions that may be detrimental to the bondholders. These covenants may be related to various ratios that must be maintained, working capital amounts, or even dividend payments. One such requirement is a sinking fund requirement. A sinking fund is a separate fund into which the company must transfer a certain amount of money each year. The money accumulated in this fund will be used to retire the bonds as they come due.

Call Provision

A call provision enables the issuing company to repurchase the bonds (call the bonds) at their option. This is very beneficial to the issuer (and therefore not helpful to the investor) because the issuer can call these bonds (retire them) if the interest rate in the market falls below the rate that they are paying in interest on the bonds. In the place of these now-retired bonds, the issuing company can issue new bonds at a lower interest rate. Bonds do not need to contain a call provision, but management may include one.

Put Provision

Bonds may also be putable. This is similar to callable, except that the option to retire the bond belongs to the purchaser of the bond. If certain events occur or the issuing company violates any bond covenants, the investor can require that the issuer repurchase the bonds. The price that the purchaser must pay will either be specifically established or will be able to be calculated from the indenture.

Convertibility

Convertible bonds may be converted by the bondholder into a stated number of shares of common stock at any time during the bond’s life. This is a very advantageous provision for the holder if the price of the firm’s common stock increases significantly during the bond’s life. In addition, as a result of the significant potential benefit to the holder, this provision substantially reduces the interest rate paid by the bond.

Benefits of Investing in Bonds

Bonds offer a range of advantages to an investor:

Capital Preservation

Capital preservation means protecting the absolute value of your investment via assets that promise a return of principal. Because bonds typically carry less risk than stocks, these assets can be a good choice for investors with less time to recoup losses.

Income Generation

Bonds provide a fixed income at regular intervals through coupon payments.

Diversification

Investing in a balance of stocks, bonds, and other asset classes can help you build a portfolio that seeks returns but is resilient through all market environments. Stocks and bonds typically have an inverse relationship, meaning that bonds become more appealing when the stock market is down.

Risk Management

Fixed income is broadly understood to carry lower risk than stocks. This is because fixed-income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events.

Tax Benefit

Many bonds have preferential tax treatment where initial investment provides tax benefit through capital gains exemption and deduction. Further coupon payments are exempt from tax—for example, Capital Gain Bonds u/s 54 EC issued by NHAI, REC.

Types of Bonds

Domestic Bonds

Types of domestic bonds could be as below:-

Straight Bonds

The majority of bonds are “straight” or “plain vanilla” bonds that pay a fixed interest amount (coupon) on regular dates and have a fixed maturity date (also known as the redemption date) when the face value of the bond is repaid to investors.

Floating Rate Notes

Bonds are often referred to as fixed-income securities. However, variable rate bonds exist and are named floating rate notes (FRNs) or variable rate notes. These pay a coupon that goes up or down according to changes in an index, e.g., the Repo Rate or the inflation rate.

Zero-Coupon Bonds

Zero-coupon bonds do not pay any interest, but they sell at a price significantly less than the face value. The significant discount on the sale of the bonds offsets the fact that there is no interest payment. In a sense, all of the interest is withheld until maturity and paid at that time. The advantage to the issuer is that there is no cash outlay for the interest payment.

Perpetual Bonds

Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds enjoy interest throughout.

Subordinated Bonds

Bonds that are given less priority than other bonds of the company in cases of a closedown are called subordinated bonds. In liquidation cases, subordinated bonds are given less importance than senior bonds, which are paid first.

Bearer Bonds

Bearer Bonds do not carry the name of the bondholder, and anyone who possesses the bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by the bondholder, anyone else with the paper can claim the bond amount.

Income Bonds

Income bonds pay interest only if the company achieves a certain income level. As a result, these bonds are riskier for the purchaser of the bonds because the interest paid by the issuer is not guaranteed, and therefore, the bonds will carry a higher interest rate.

Serial Bonds

Serial bonds are bonds issued so that they mature over some time. For example, some of the bonds mature each year. This enables the issuer of the bonds to retire over time without needing a single, large cash payment. Also, investors can choose the maturity period that fits their needs.

Participating Bonds

Participating bonds can also participate in dividends (the distributions of profits) of the company during a period of high profits.

Bonds with ‘Sweeteners’

A ‘sweetener’ is added to a plain bond to make it more attractive. Sweeteners (bells and whistles) are added to enhance the return on otherwise precarious debt or reduce the coupon on otherwise too-expensive debt. Sweeteners may consist of rights to equity (equity kickers) or, for instance, a right to a premium on redemption. A bond with some form of equity kicker would be a hybrid bond since it shares equity and debt characteristics.

Convertible bonds and bonds with equity warrants are examples of hybrid bonds. A convertible bond is a bond that gives the holder an option to accept shares1 instead of cash on the maturity of the bond. The conversion terms are agreed upon at the outset, and the holder would exercise their option if the share price exceeded the conversion price.

A company might use a conversion option as a ‘sweetener’ to investors to enable the issue of a bond at a lower coupon rate. However, the number of convertible bonds a company can issue must be within the rules protecting the pre-emption rights of existing shareholders if applicable. Bonds with equity warrants2 attached are very similar, although the warrant can be traded separately from the bond after issue.

International Bonds

There are two types of international bonds: foreign bonds and Eurobonds. Both are sold outside the issuing companies’ home countries (for an India-based company, the bonds are sold outside India), but they differ in currency in that they are denominated.

Foreign bonds are issued in one country (not the issuing corporation’s home country) and are usually denominated in the currency of the country where they are sold. For example, an Indian company may issue bonds in the USA that are denominated in USD. Usually, the proceeds of these bond issues are used to finance company assets in a foreign country.

Eurobonds are international bonds denominated in a currency different from the country they are sold in. A Eurobond can be issued in any country’s currency. It is usually issued in the currency of the issuer’s home country, but that is not a requirement. There can be as many as three different countries involved in a Eurobond: the country where the issuing company is located, the country where the bond is issued, and the country whose currency the bond is issued in. For example, an Australian company could issue a Eurobond in Canada denominated in Japanese yen.

Advantages of Eurobonds

• They allow an issuer to choose the country to offer its bond, depending upon the regulatory constraints of the various countries, and
• The issuer can choose to denominate the Eurobond in whatever currency it wishes. Eurobonds have lower costs than domestic bonds because they are outside the control of the country’s monetary authorities.

Eurobond arose because U.S. issuers initially issued these bonds in European countries. However, their use has expanded so that they are now issued in many countries by issuers of many nationalities. Eurobonds also have nothing to do with the euro, the currency of the European Union. Eurobonds existed long before the euro came into use.

Corporate Bonds

Some of the bonds that are issued by corporates are:

Mortgage Bonds

These bonds are secured by real property such as land, buildings, or equipment.

First Mortgage Bonds

This type of bond has first claim to such assets, and as such, they are referred to as “senior securities.”

Collateral Trust Bonds

A pledge of other financial assets such as common shares, bonds, or treasury bills secures collateral trust bonds.

Debentures

Corporate debentures are similar to bonds but are generally unsecured or secured by a general floating charge over the company’s unencumbered assets (i.e., those that have not been pledged as security for other debt obligations). Subordinated debentures are junior to some additional security in a manner that may be ascertained from the prospectus.

Corporate Notes

Corporate notes are unsecured promises to pay interest, repay the principal, and rank behind all other fixed obligations of the borrower. Secured or collateral trust notes are secured by notes pledging assets purchased with the loan proceeds, such as automobiles. Secured term notes are secured by a written promise to pay regular installments, and these notes trade in the money market.

Real Estate Bond

Real estate bonds are those issued to finance real estate projects. They typically involve one or more of the following features that limit the investors’ risk:

• The lender owns the development outright or has shares in it;
• Income participation deals;
• Rolling over short-term loans;
• long-term mortgage-based loan with rates revised periodically; or
• mortgage bonds are combined with share purchase warrants.

Bond Securitization

A significant development in the bond markets in recent years has been the growth of securitization, and it is helpful to understand the possibilities the market offers. Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets.

For instance, mortgage-backed security is the principal and interest payments of a collection of mortgage loans back asset-backed security whose cash flows. The market originated in the USA when the Federal National Mortgage Association (FNMA or Fannie Mae) was established to buy mortgages on the secondary market. These were then pooled and bonds issued as “mortgage-backed securities” to investors. This converted a long-term asset owned by a mortgage provider (the mortgage) into cash, improving its liquidity and enabling it to focus on selling mortgages rather than financing them. However, the downside of this was that mortgage providers became so focused on selling mortgages they failed to consider the creditworthiness of the mortgagee.

It was this market that many people suspected of being at the root of the financial crisis in the late 2000s.

Important: Never trade in anything you do not fully understand (even if your advisers say they know).

Credit Ratings

Credit ratings provide credit risk measures and may reduce the amount of research an investor has to undertake as part of the decision-making process. They thus make bonds more marketable and are an established feature of the international bond market.

The issuer appoints Credit Rating Agencies to give a credit rating to a new bond issue which the agency will monitor from the time of issue to maturity. The issuer pays the agency’s fees, and the credit rating is publicized.

Medium Term Note

Many investment-grade companies have established medium-term note (MTN) programs to finance their medium-term financing needs. An MTN is a form of bond. An MTN program is a funding structure borrowers use to issue bonds opportunistically under an umbrella documentation set.

The main advantage of MTN programs for issuers is that there is no requirement to produce a complete set of legal documents each time the issuer wishes to raise additional debt in the capital markets. Instead, a pricing supplement that sets out the terms of each specific issue of notes is used on each issue. This makes access to the debt capital markets easier and cheaper than individual bond issues.

Issues of MTNs can be made at any time and for any maturity, ranging from about nine months to many years (sometimes as long as 30 years). They can be issued physically or electronically, and one or more rating agencies usually rate the program.

MTNs are like Bonds

• Interest may be on a fixed rate or floating rate basis.
• MTNs are typically unsecured debts.
• MTNs may be interest-bearing, deeply discounted, or zero-coupon securities.
• MTNs may have fixed maturities or be callable3 at the issuer’s option.
• MTNs may be issued in a wide range of currencies.

Risks in Bond Investment

Different types of risks associated with bonds are:-

Interest Rate Risk

When interest rates rise, bond prices fall, and the bonds you currently hold can lose value. Interest rate movements are the primary cause of price volatility in bond markets.

Inflation Risk

Inflation is the rate at which goods and services prices rise over time. If the inflation rate outpaces the fixed income a bond provides, the investor loses purchasing power.

Credit Risk

Credit risk (also known as business risk or financial risk) is the possibility that an issuer could default on its debt obligation.

Liquidity Risk

Liquidity risk is the possibility that an investor wishes to sell a bond but cannot find a buyer. Bonds freeze your investment for a fixed period. For example, if you buy a 10-year bond, you can’t redeem it for ten years. This creates the potential for your initial investment to lose value. Stocks, on the other hand, could be sold at any time.

Default Risk

Whenever a purchaser of bonds buys the bonds, the buyer assumes several different risks. One of the main risks the buyer takes is the risk that the issuing company will default on the bond obligation. This means that the issuing company will not be able to pay the interest due on the bond, the principal amount when the bond is due, or both.

This default risk is generally measured by independent analysis performed by financial services companies like Moody’s and Standard & Poor’s. Their rating schemes rank the bond from the highest quality (low default risk) to the lowest quality (high chance of default). The lower the rating, the higher the interest rate the bond will carry.

Grading of Bonds

Investment Grade Bonds

Companies have a high capacity to repay, and there is little risk of default (AAA to BBB for S&P and Aaa to Baa for Moody’s).

Junk bonds

These bonds are issued in leveraged buyouts and mergers and are very risky. However, they also carry the potential of very high rewards because they pay a high-interest rate. For companies in a difficult financial position, these may be the only source of financing available. The company will have no choice but to pay their bonds’ high-interest rates (BB and below for S&P and Ba and below for Moody’s).

Buying and Selling Bonds

The allure of any bond is its yield and the total return, which is the sum of the interest payments added to the principal.

There are two ways of making money on bonds:-

• The first is to collect the interest payments until the bond matures.
• The second way is to sell the bond for more than you paid for it before the point of maturity. By selling the bond through a broker, it’s possible to make a capital gain depending on what has happened to the issuer’s credit quality.

Bond Purchase and Trading

You can buy and sell bonds on the open market just like you buy and sell stocks. The bond market is much larger than the stock market.

Here are a few terms you should be familiar with, though, when buying and selling bonds:

• The market price is the price at which the bond trades on the secondary market.
• Selling at a premium is the term used to describe a bond with a market price higher than its face value.
• Selling at a discount is the term used to describe a bond with a market price lower than its face value.

Types of Risks in Bonds

Interest-rate Risk

When interest rates rise, bond prices fall, and the bonds you currently hold can lose value. Interest rate movements are the primary cause of price volatility in bond markets.

Inflation Risk

Inflation is the rate at which goods and services prices rise over time. If the inflation rate outpaces the fixed income a bond provides, the investor loses purchasing power.

Credit Risk

Credit risk (also known as business risk or financial risk) is the possibility that an issuer could default on its debt obligation.

Liquidity risk

Liquidity risk is the possibility that an investor wishes to sell a bond but cannot find a buyer. Bonds freeze your investment for a fixed period. For example, if you buy a 10-year bond, you can’t redeem it for 10 years. This creates the potential for your initial investment to lose value. Stocks, on the other hand, could be sold at any time.

Default Risk in Bonds

Whenever a purchaser of bonds buys the bonds, the buyer assumes several different risks. One of the main risks the buyer takes is the risk that the issuing company will default on the bond obligation. This means that the issuing company will not be able to pay the interest due on the bond, the principal amount when the bond is due, or both.

This default risk is generally measured by independent analysis performed by financial services companies like Moody’s and Standard & Poor’s. Their rating schemes rank the bond from the highest quality (low default risk) to the lowest quality (high chance of default). The lower the rating, the higher the interest rate the bond will carry.

Based upon ratings, bonds are considered either:

• Investment Grade (High Quality) bonds – companies have a high capacity to repay, and there is little risk of default (AAA to BBB for S&P and Aaa to Baa for Moody’s), or
• Junk bonds – these are issued in leveraged buyouts and mergers and are very risky. However, they also carry the potential of very high rewards because they pay a high-interest rate. For companies in a difficult financial position, these may be the only source of financing available. The company will have no choice but to pay their bonds’ high-interest rates (BB and below for S&P and Ba and below for Moody’s).

Credit Risk

Credit risk concerns the issuer’s ability to make timely payments on interest and principal. Credit risk appears in three forms.

• Default risk is related to untimely or missed payments, which is a default on the part of the issuer.
• Downgrade risk is related to the possibility of a downgrade of an issuer’s debt due to a deteriorating ability to make interest payments.
• Spread risk is the chance that the price relative to a benchmark bond will fall. Evaluating an issuer’s overall credit risk is the purpose of credit analysis.

Credit Analysis

Credit analysis involves a detailed study of the issuer to anticipate changes in credit risk. Credit analysis closely looks at the following:

• The issuer’s existing obligations and the collateral protection available for creditors
• Liquidity and borrowing needs
• Cash flow needs.

Regarding government securities, credit analysis also considers:

• Monetary policy and price stability.
• Fiscal policy and budget flexibility.
• Public debt burden.
• Growth prospects for the economy.
• Economic structure.
• External debt levels and liquidity.
• Political risk.

Credit analysis is a full-time job. Many creditors and lenders depend on recognized credit rating agencies for analysis. Some prominent global credit rating agencies are; Moody’s, Standard and Poor’s, Fitch Ratings, etc.

Bond Rating Service provides independent rating services for many debt securities. Each agency provides an opinion on the creditworthiness of an issuer. As such, the agencies can determine the cost of borrowing for the firms they cover.

Agencies review their ratings regularly and conduct reviews after significant financial developments. Agencies may also provide an outlook or place the issuer on a credit watch list. An issuer is reviewed with positive, neutral, or negative implications on the watch list. Debt instruments are classified as investment grade, speculative grade, or junk grade based on credit rating provided by the rating agencies.

Yield Curve Risk

The chance that changes in the shape of the yield curve can cause debt of differing maturities to change in value at different rates than expected is yield curve risk. The yield curve represents the term structure of interest rates, the relationship between interest rates, and the time to maturity.

The yield curve is constructed from the bonds of a single issuer, the most important of which is the Government. Its benchmark yield curve prices all other debt in the market.

The yield curve has been observed to assume four shapes as follows:-

Upward Sloping Yield Curve

The yield steadily rises as maturity increases. The shape is also known as a positive or normal yield curve. This is the most common shape.

Inverted Yield Curve

The yield declines as maturity increases. Inverted yield curves are a leading indicator of recession.

Flat Yield Curve

Long-term rates are very close to short-term rates.

Humped Yield Curve

A rare event occurs when the yield at a particular maturity, for example, medium-term bonds, is higher than yields at short- and long-term maturities.

As the yield curve moves from one shape to another to reflect the market level of interest rates, it can shift in one of two ways.

• Parallel: All maturities move up or down by about the same amount.
• Twists: One end of the yield curve moves more than the other end or in the opposite direction. As a result, the curve becomes steeper or flatter. Usually, shorter-term rates move more quickly than long-term rates.

Spreads and Market Pricing

All government bonds are rated at the highest credit quality. Thus, they set the benchmark borrowing rate for all other debt in the market. To attract buyers, non-government bonds must trade at higher yields. The additional yield is the spread, expressed in basis points or hundredths of a percent.

Example: Bond A, yielding 5.11%, trades at an 11 basis point spread over Bond B, which yields 5.00%.

The spread generally reflects the risk borne by owners of non-government bonds and becomes more comprehensive as the risk inherent in an issue increases. The exchange of one bond for another in the belief that the current spread is out of line and will return to historical norms by the end of the holding period is known as an Intermarket Spread Swap.

Spreads reflect the compensation for assuming risk beyond the relative safety of government bonds. There are many risks to account for, but the main risks arise from; 1) default, 2) embedded options, and 3) liquidity.