Bond (finance)

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (ex semi annual, annual, sometimes monthly).^[1]

Thus a bond is like a loan: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

1 Issuance
2 Features
3 Types
- 3.1 Foreign currencies
4 Reckoning
5 Investing in bonds
- 5.1 Bond indices
6 See also
7 References
8 External links

Issuance

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have the direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so.

In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon.^[2] However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market.^[3]

Sometimes the documentation allows the issuer to borrow more at a later date by issuing further bonds on the same terms as before, but at the current market price. This is called a tap issue or bond tap.^[4]

Features

The most important features of a bond are,

nominal, principal, par or face amount — the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.
issue price — the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. 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 nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities:
- short term (bills): maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments)
- medium term (notes): maturities between six to twelve years;
- long term (bonds): maturities greater than twelve 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 vary with 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 the bond holder would give the coupon to a bank in exchange for the interest payment. Coupons can be paid at different frequencies. It is generally semi-annual or annual.

The "quality" of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors.
- Indentures and Covenants — An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders.
- High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk 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:
- Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
- Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. These are referred to as retractable or putable bonds.
- call dates and put dates—the dates on which callable and putable bonds can be redeemed early. There are four main categories.
  - A Bermudan callable has several call dates, usually coinciding with coupon dates.
  - A European callable has only one call date. This is a special case of a Bermudan callable.
  - An American callable can be called at any time until the maturity date.
  - A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event 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 be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
exchangeable bond allows for exchange to shares of a corporation other than the issuer.

Types

The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.
Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).
Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United Kingdom was the first sovereign issuer to issue inflation linked Gilts 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 indexed on a business indicator (income, added value) or on a country's GDP.
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero.
Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets.^[5] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.^[6]
Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.
Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the “full faith and credit” of the federal government. For that reason, this type of bond is often referred to as risk-free.
Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Build America Bonds (BABs) is a new form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds.^[7]
Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.^[8]
Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.
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. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.
Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.
Climate bond is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation or adaptation related projects or programs.

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 domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law. Not all of the following bonds are restricted for purchase by investors in the market of issuance.

Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S^[9]
Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US market
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
Uridashi bond, a non-yen-demoninated bond sold to Japanese retail investors.
Shibosai Bond is a private placement bond in Japanese market with distribution limited to institutions and banks.
Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or government^[10]
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 the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia
Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean market^[11]
Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean market^[12]
Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the Taiwan market^[13]
Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's Republic of China market^[14]
Dimsum bond, a Chinese renminbi-denominated bond issued by a Chinese entity in Hong Kong. Enables foreign investors forbidden from investing in Chinese corporate debt in mainland China to invest in and be exposed to Chinese currency in Hong Kong.^[15]
Huaso bond, a Chilean peso-denominated bond issued by a non-Chilean entity in the Chilean market.^[16]

Reckoning

Investing in bonds

Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.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 stocks. 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 of dividend payments. Bonds are liquid – it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks – and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can also be risky but less risky than stocks:

Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk.

Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk.

Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has 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 is immediately "marked to market" or not). If there is any chance a holder of individual bonds may 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 in terms of its duration. Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the credit rating of the issuer – for instance if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution 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 a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Bond indices

References

^ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 197, 507. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.
^ http://www.dmo.gov.uk/index.aspx?page=Gilts/Operations
^ http://www.housingfinance.com/ahf/articles/2005/march/bond1.html
^ Tap issue at Investopedia
^ Eason, Yla (June 6, 1983). "Final Surge in Bearer Bonds" New York Times.
^ Quint, Michael (August 14, 1984). "Elements in Bearer Bond Issue". New York Times.
^ Benjamin Shepherd. "A Slice of the Pie". InvestingDaily.com. http://www.investingdaily.com/ruk/18220/a-slice-of-the-pie.html. Retrieved 2010-01-19.
^ no byline (July 18, 1984). "Book Entry Bonds Popular". New York Times.
^ "Eurodollar deposit". http://www.riskglossary.com/link/eurodollar_deposit.htm. Retrieved 2009-01-05.
^ no byline (2005-12-05). "Ninja loans may yet overtake samurais". The Standard. http://www.thestandard.hk/news_detail.asp?we_cat=10&art_id=7106&sid=5769214&con_type=1&d_str=20051205. Retrieved 2008-12-09.
^ Batten, Jonathan A.; Peter G. Szilagyi (2006-04-19). "Developing Foreign Bond Markets: The Arirang Bond Experience in Korea" (PDF). IIS Discussion Papers (138). http://www.tcd.ie/iiis/documents/discussion/pdfs/iiisdp138.pdf. Retrieved 2007-07-06.
^ Gwon, Yeong-seok (2006-05-24). "‘김치본드’ 내달 처음으로 선보인다 (Announcement: first 'Kimchi Bonds' next month)". The Hankyoreh. http://www.hani.co.kr/arti/economy/stock/126171.html. Retrieved 2007-07-06.
^ Chung, Amber (2007-04-19). "BNP Paribas mulls second bond issue on offshore market". Taipei Times. http://www.taipeitimes.com/News/biz/archives/2007/04/19/2003357355. Retrieved 2007-07-04.
^ Areddy, James T. (2005-10-11). "Chinese Markets Take New Step With Panda Bond". The Wall Street Journal. http://online.wsj.com/article/SB112893305062664267.html?mod=article-outset-box. Retrieved 2007-07-06.
^ Stein, Peter (2010-11-01). "‘'Dim Sum Bonds' on the Menu for Foreign Investors". The Wall Street Journal. http://online.wsj.com/article/SB10001424052702304354104575568180321350908.html. Retrieved 2010-11-01.
^ Moura, Fabiola (2011-03-26). Bloomberg. http://www.bloomberg.com/news/2011-03-27/chile-expects-more-huaso-bond-sales-in-coming-months-larrain-says.html.

External links

Bonds links at the Open Directory Project

Bond market

Bond · Debenture · Fixed income

Types of bonds by issuer	Agency bond · Corporate bond (Senior debt, Subordinated debt) · Distressed debt · Emerging market debt · Government bond · Municipal bond · Sovereign bond

Types of bonds by payout	Accrual bond · Auction rate security · Callable bond · Commercial paper · Convertible bond · Exchangeable bond · Extendible bond · Fixed rate bond · Floating rate note · High-yield debt · Inflation-indexed bond · Inverse floating rate note · Perpetual bond · Puttable bond · Reverse convertible · Zero-coupon bond

Bond valuation	Clean price · Convexity · Coupon · Coupon yield · Credit spread · Current yield · Dirty price · Duration · I-spread · Mortgage yield · Nominal yield · Yield to maturity · Z-spread

Securitized products	Asset-backed security · Collateralized debt obligation · Collateralized mortgage obligation · Commercial mortgage-backed security · Mortgage-backed security · Yield-curve spread

Bond options	Callable bond · Convertible bond · Embedded option · Exchangeable bond · Extendible bond · Option-adjusted spread · Puttable bond

Institutions	Commercial Mortgage Securities Association (CMSA) · International Capital Market Association (ICMA) · Securities Industry and Financial Markets Association (SIFMA)

Corporate finance and investment banking

Capital structure

Senior secured debt · Senior debt · Second lien debt · Subordinated debt · Mezzanine debt · Convertible debt · Exchangeable debt · Preferred equity · Warrant · Shareholder loan · Common equity · Pari passu

Transactions
(terms / conditions)

Equity offerings	Initial public offering (IPO) · Secondary market offering (SEO) · Follow-on offering · Rights issue · Private placement · Spin out · Equity carve-out · Greenshoe (Reverse) · Book building · Bookrunner · Underwriter

Mergers and acquisitions	Takeover · Reverse takeover · Tender offer · Proxy fight · Poison pill · Staggered board · Squeeze out · Tag-along right · Drag-along right · Pre-emption right · Control premium · Due diligence · Divestment · Sell side · Buy side · Demerger · Super-majority · Pitch book

Leverage	Leveraged buyout · Leveraged recap · Financial sponsor · Private equity · Bond offering · High-yield debt · DIP financing · Project finance · Debt restructuring