What is a bond?
In simple terms, a Bond is a contract between a lender and a borrower, which includes the principal amount, interest rate, term / period, start date, end date, payment details and few other details. It is a type of a Fixed Income Instrument used by Investors and Institutions to park some of their funds for a relatively safer return. The returns on investments in a Bond is relatively lower as compared to the Stock investment. However, it also carries less market risk. Bonds are issued by private institutions, listed companies, government organizations, municipalities, states, and sovereign governments to finance projects and operations. Bonds are rated by independent financial rating agencies, such as Moody’s, S&P, Morningstar etc. These ratings vary from AAA to D, based on the rating agency.
Key Bond Terminology:
- Issue Price: This is the original sale price of the Bond. This is the price that the Investor pays to the issuer of the Bond (Borrower).
- Face Value: This is the predefined value of the Bond at maturity.
- Coupon Rate: This is the percentage interest rate that the Investor will receive on the Face Value.
- Coupon Dates: These are the interest payment dates for the Bond.
- Maturity Date: This is the date on which the Bond will mature and the Investor will receive his proceeds from the Bond maturity. The issuer of the Bond has the obligation to pay out the proceeds on maturity.
- Yield to Maturity: This is the annualized rate of return of a Bond on the price paid to buy the Bond. The calculation is based on the value at the maturity of the Bond. Bonds can be sold in the secondary market by one Investor to another. The Yield to Maturity for the new bond holder may be different, based on what price s/he is buying it from the first Investor.
- Zero-Coupon Bond: These are the type of Bonds, in which there is no regular coupon (interest) payment. Rather the initial price of the Bond is discounted to reflect the rate of interest or rate of return. The difference between the Face Value and the purchase price of such bonds can be used to calculate the Yield.
- Callable Bonds: Callable Bonds are those which can be bought back by the Issuer prior to maturity by paying the principal amount. This happens when the interest rate in the market goes down and the Issuer has the opportunity to sell new Bonds at a lower rate. This type of Bond is riskier and less profitable for the Investors.
- Puttable Bond: Puttable Bonds are those which can be sold by the Investor back to the Issuer and get the principal investment back. This can happen, if the interest rates rise significantly and the Investor has the opportunity to buy similar Bonds at a higher coupon rate from the market.
- Convertible Bond: Convertible Bonds are those which can be converted to the shares of the company. There are certain restrictions in converting to company shares, such as a minimum stock price. This can be useful for the Issuer, if they are at the early stage of their growth, to save money on interest payment, avoid paying out on Bond maturity and expand their future shareholder base.
Types of Bonds:
There are a number of types of Bonds issued and used in the financial market. Some of the popular ones are:
- Government Bonds: These Bonds are issued by the Governments as the sovereign debt. US Government Bonds are categorized into 3 types based on maturity: (a) Bills for less than a year maturity (b) Notes for 1 to 10 years maturity and (c) Bonds for over 10 years maturity. Since these Bonds are backed by the Government, these are considered as safe investments.
- Corporate Bonds: Corporate Bonds are issued by private or listed companies to raise money for their operations, new projects, or overall growth. It is easier for an established business to raise money through Corporate Bonds, rather than bank loans or selling shares. The terms and conditions are also dictated by the company and hence is normally favorable to them.
- Municipal Bonds: These debt securities are provided by cities, regions, counties, or municipalities. Some of them are Tax Free, meaning the Investor will not pay any taxes on the returns from these Bonds. Many of the Municipal Bonds are backed by the revenues generated by the specific projects such as from highway tolls.
- Agency Bonds– Agency Bonds are issued by organizations, which are affiliated with the Government. Or it can also be issued by a non-Treasury Government department.
Correlation of Bonds to Equities:
In Stocks, investors own a certain number of shares of the company. In Bond, Investors lend money to the company as debt. The advantage of Bonds over Stocks is that, in a situation of bankruptcy of the issuer, bondholders are paid first and stockholders at the very end.
In terms of the price movement, Bonds and Stocks have inverse correlation. Bond value is driven by interest rate, while Stock price is driven by company performance. If the overall economy is not doing good, the chances of Stock price going lower is high. At the same time, a bad economy drives the interest rate down, causing the Bond value to go up (as the interest rate of Bond is already fixed). Hence, generally (and not always) Bond prices go up when Stock prices (in the overall market) go down and vice versa. This is an important correlation to understand, as this feeds into market timing and trading strategies.
Benefits of Bonds Trading:
- Bonds are less volatile and less risky as compared to other securities or financial assets.
- They provide secure and consistent returns throughout the term.
- Bonds offer higher interest rates compared to savings accounts in banks.
- Some Bonds also offer tax exempted returns
- Bond market has enough liquidity to buy or sell the Bonds. This is particularly true for the investment grade Bonds. This may not be true for Junk grade Bonds.
Risks of Bonds Trading:
- Bond trading involves credit risk in which the Issuer may default on the interest rates or principal amount at maturity.
- If the Investor is entering into higher risk Bonds (e.g., Junk Bonds), there is a higher risk of default by the Issuer.
- If the interest rates move in unfavorable direction, the Bond may lose significant value.
- Callable Bonds can be called back (bought back by the Issuer) if the interest rate decreases.