Bond – Meaning, How Bond Works, and 3 Examples of Bond
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Bonds are predominantly utilized within the business, crucial in forging connections with enterprises. They hold significant value in fostering trust and facilitating progress and prosperity. In this blog, I will explore more on bonds for more clarification.
Bonds are transferable entities that can be traded in the secondary market, similar to stocks. While they possess a face value, they can be bought or sold at a price lower or higher than that value.
Additionally, bondholders possess a financial interest in a business, as they have the right to receive interest payments and repay the principal amount upon maturity. This attribute renders bonds a more secure investment compared to stocks.
Nevertheless, unlike equity holders, bondholders do not have ownership rights or a share in the company’s profits.
How Does a Bond Work?
A bond comprises three key elements: the principal amount, the coupon rate, and the maturity date. These three components are employed in the calculation of a bond’s yield.
These attributes elucidate the connection between the issuer and the investors. The following characteristics:
An issuer refers to a company or governmental entity (such as a city, state, or national authority) that offers debt instruments to borrow funds from individual and corporate investors.
2. Par Value:
Each bond is assigned a face value, indicated on the bond itself, representing the amount the bondholder is entitled to receive upon the maturity date.
3. Market Value:
It is the value at which the bonds are bought and sold in the secondary market.
The interest rate presented by the issuer on these debt securities is known as the coupon rate. Furthermore, the annual interest disbursed to the investors is referred to as the coupon value.
5. Coupon Date:
The coupon date is the specific day investors receive regular interest payments.
6. Maturity Date:
At the maturity date, the bond can be redeemed. The maturity period of these debt instruments can vary, ranging from short-term to medium-term, to long-term durations.
A bond’s yield refers to the percentage return earned by an investor who holds the bond until its maturity.
8. Credit Rating:
Major rating agencies like Moody’s, Standard and Poor’s, and Fitch assess and assign ratings to various bonds according to their level of risk. Bonds with higher risk are assigned lower ratings and are called junk bonds.
Types of Bonds
The following are the types of bonds:
1. Fixed Rate
These financial instruments feature fixed coupon rates that remain consistent over the entire duration of their existence.
2. Floating Rate:
The coupon rates of these securities are tied to a benchmark interest rate, such as the LIBOR (London Interbank Offered Rate) or the U.S. Treasury Bill rate. As these reference rates fluctuate, the coupon rates are classified as floating. For instance, the interest rate may be specified as the U.S. Treasury Bill rate plus 0.25%, and it is recalculated periodically.
These corporate debt securities are issued by companies and offered to various investors. They can be categorized as either secured or unsecured. The level of backing for these securities relies on the company’s payment capacity, closely tied to its potential future earnings derived from its business activities. Credit rating agencies carefully evaluate these aspects before providing their confirmation or rating.
Government bonds are issued by the national government, assuring regular interest payments and the repayment of the face value upon maturity. The terms under which the government can offer these securities are contingent on its creditworthiness within the market.
Nations, states, or cities issue these debt instruments to raise funds for various ongoing and upcoming projects. The income generated from these securities is generally exempt from state and federal tax obligations.
Unlike other bonds, zero-coupon bonds do not provide regular interest payments throughout their term. Instead, they are typically issued at a price below their par value, making them an appealing investment option.
The difference between the purchase price and the par value is accrued over time, and the complete principal amount (par value) is repaid upon maturity. Financial institutions also have the option to issue these bonds by separating the coupons from the principal amount.
6. High Yield:
Debt securities, commonly known as junk bonds, receive ratings below the investment grade by credit rating agencies. Consequently, to entice investors, the issuers offer a higher rate of return.
Due to their lower credit quality, these bonds are expected to provide a higher yield. Investors willing to assume greater risk in exchange for a higher yield opt for these bonds.
It grants holders the ability to convert them into specific equity shares. These securities are categorized as hybrid instruments since they possess characteristics that are a combination of both equity and debt.
These debt instruments connect the principal amount and the interest payments with inflation indexes, such as the consumer price index. As a result, they safeguard investors from the impact of inflation in the economy, ensuring the protection of their investments.
Subordinated bonds belong to a category of unsecured corporate debt securities that possess a lower priority compared to other instruments in the event of liquidation. They entail a higher level of risk when compared to senior bonds.
Subordinated bondholders receive compensation only after the payment of creditors and senior bondholders. These bonds typically carry a lower credit rating. Examples of subordinated bonds include debt instruments issued by banks, asset-backed securities, and so on.
Foreign companies issue these debt securities in the domestic market to raise funds in the local currency. Since most investors would typically be from the domestic market, it provides an opportunity to benefit from a diversified portfolio.
Examples of Bonds
- On December 13, 2020, Tina released bonds with a five-year maturity. These bonds were priced at $100 per bond and carry a 7% coupon rate. The yield to maturity (YTM) for these bonds is 8%.
2. On March 5, 2020, Tina issued two-year notes. These notes were priced at $500 each and had a coupon rate of 6%. The first interest payment was made six months after the issue date. The yield to maturity (YTM) for these notes is 6%.
3. A bond with a 5.5% yield offers a 6% coupon rate. Will this bond’s price be higher or lower than the principal’s?