Bonds in finance
|Bonds in finance|
Bond (finance) is an instrument of indebtedness of the bond issuer to the holders. This is a long-term, interest-paying loan raised by a government or a company to finance expenditure or investment, redeemed after a fixed period.
Government bonds, which can last up to 30 years or more, are known as Treasury notes and Treasury bonds in the US and Treasury stock, gilt-edged stock or just gilts in Britain.
Large corporate borrowers find it cheaper to borrow directly by issuing bonds (usually underwritten by an investment bank) than to borrow from a commercial bank.
Features of bonds
- Principal- the amount of capital making up a loan. It is calculated multiplying Par Value and Price (represented as percentage).
- Maturity date- the date on which bond will be repaid, usually 5 to 10 years.
- Face value/nominal value/par value – the price written on a security (which never changes).
- Coupon- the amount of interest paid by bond. The buyers of bond lend money to the issuer and generally receive fixed, six-monthly or annual interest payments.
- Yield- the rate of income a bondholder receives, taking into account the bond's purchase price.
Types of bonds
Some companies issue floating- rate notes -bonds whose coupon varies with market interest rates- especially when interest rates are high and expected to fall.
If they wish to pay a lower interest rate, companies can also issue convertible bonds, which are that' give the owner the option to exchange them for a fixed number of shares of the company's common stock. Convertibles pay lower interest than ordinary bonds because the buyer gets the possibility rates of making a profit with the convertible option, and their value increases if the stock price rises.
Some companies also issue warrants attached to bonds, giving the right, but not the obligation, to buy stocks in the future at a particular price. Although they are usually issued with bonds, warrants can be detached from the bonds and traded separately. Like convertibles, they allow an issuer to reduce the interest rate that the bond offers.
Some companies issue zero coupon bonds which pay no interest but are sold at a discount on their par value, and redeemed at 100% at maturity. Some investors buy them in order make a capital gain at maturity, which is taxed at a lower rate than that applied to interest payments.
bonds that pay a high interest rate are called high yield bonds or junk bonds. Some are finance leveraged buyouts, others are issued by companies with a credit rating below investment grade, and therefore with a higher risk of default.
Finance risk of bonds trade
Corporate bonds are generally considered to be safer than stocks, because a company that cannot repay its debts can be declared bankrupt and have its assets sold it repay creditors, including bondholders. However, a company's financial situation can change during the life of a bond. Furthermore, on average stocks pay a higher return than bonds over the medium or long term. Issuers are given credit ratings or credit rating agencies. The highest grade (Aaa or AAA) means that there is virtually no risk of default ;lower grades (e.g. AA BBB, BB, B +, etc.) indicate progressively greater degrees of risk that the borrower will not be able it repay Governments and companies with higher credit ratings can borrow at lower rates.
Tax deductible bonds
For companies, debt financing (issuing bonds) has an advantage over equity financing (issuing stocks) in that bond interest is tax deductible: companies deduct interest payments from their profits before paying tax, whereas dividends paid to stockholders come from already-taxed profits. On the other hand, debt has to repaid, unlike equities which do not, and unlike dividends, bond interest has to be paid, even in a year without any profits it deduct it from.
The price of bonds
bonds are traded on the secondary market by banks and brokerage companies which act as a market-makers on behalf of their customers. Bond traders make a market with a bid price at which they buy and an offer price at which they sell, with a very small spread between them. The price of bonds on the secondary market includes accrued interest.
The price of bonds varies inversely with interest rates. If interest rates, so new bond issues pay a higher rate, existing bonds lose value, and sell for less than the nominal value (below par). Conversely if interest rates fall, existing bonds paying more than the market rate will logically increase in value, and rates more trade above par. Therefore, the yield of bond depends on both its purchase price and its coupon.
Examples of Bonds in finance
- Treasury Bonds: Treasury bonds are issued by the government and are usually referred to as "risk-free" investments. They generally have a fixed interest rate and a maturity date up to 30 years in the future. Treasury bonds are generally considered a safe investment and are widely held by investors.
- Municipal Bonds: Municipal bonds are issued by local and state governments to finance public works projects such as schools, hospitals, roads, and bridges. They are also sometimes referred to as "munis" and generally have a fixed interest rate and a maturity date up to 30 years in the future. These bonds are generally considered a safe investment and are widely held by investors.
- Corporate Bonds: Corporate bonds are issued by companies to finance their operations and expansion. They generally have a higher risk level than treasury and municipal bonds, but also offer the potential for higher returns. Corporate bonds are typically issued with a fixed interest rate and a maturity date up to 30 years in the future.
- Mortgage-Backed Securities: Mortgage-backed securities (MBS) are investments backed by mortgage loans. These securities represent an ownership interest in a pool of mortgages and generate income in the form of principal and interest payments. MBS are generally considered a safe investment and are widely held by investors.
Advantages of Bonds in finance
Bonds are a popular source of financing and offer a number of advantages, including:
- Lower Risk: Bonds are generally considered one of the least risky investments. Bondholders have a greater level of protection than stockholders, as bonds typically offer a fixed rate of interest and a stated maturity date.
- Tax Advantages: Interest payments on bonds are generally exempt from state and local taxes and may also qualify for favorable federal tax treatment.
- Diversification: Bonds can help diversify a portfolio, providing a balance to riskier investments.
- Liquidity: Bonds are generally more liquid than stocks, making them easier to buy and sell.
- Flexible Terms: Investors can customize their bond portfolios by selecting different maturities and types of bonds. This allows them to tailor their investments to meet their specific needs.
Limitations of Bonds in finance
Bonds are widely used in the finance world, but they do have certain limitations. These include:
- Interest Rate Risk: Bond prices are inversely related to interest rates. When interest rates increase, bond prices decrease, and vice versa. This can cause losses to bondholders, so investors must always be aware of the current interest rate environment when investing in bonds.
- Credit Risk: Bonds are subject to the credit risk of the issuer. If the issuer defaults on their payments or goes bankrupt, bondholders can suffer losses.
- Liquidity Risk: Bonds are generally not as liquid as stocks, so investors may not be able to sell them quickly or at the desired price.
- Reinvestment Risk: Bondholders may not be able to reinvest the cash flow from their bonds at the same rate when the bond matures. This can lead to lower returns than expected.
- Inflation Risk: Inflation erodes the purchasing power of bond returns, making them less valuable over time.
- Currency Risk: Currency fluctuations can affect the value of bond returns if the bond is denominated in a foreign currency.
Bonds in finance are an important tool for investors to earn a return on their investments. Other approaches related to bonds include:
- Equity: Equity investments involve buying a portion of a company’s stock. They offer the potential for higher returns than bonds, but also involve greater risk.
- Mutual Funds: Mutual funds are professionally managed investments that pool money from many different investors into a single portfolio of stocks and bonds.
- Exchange Traded Funds (ETFs): ETFs offer investors the ability to trade in and out of baskets of stocks or bonds with a single transaction. They are similar to mutual funds, but with the added benefit of being able to be traded like a stock.
- Options: Options are contracts that give the buyer the right, but not the obligation, to purchase or sell an underlying asset at a predetermined price. Options provide investors with the ability to hedge their investments or speculate on the price of an asset.
Overall, bonds represent just one of many financial instruments that investors can use to earn returns on their investments. Equity, mutual funds, ETFs and options are all viable alternatives for investors to consider when constructing their portfolios.
- Deacon, M., Derry, A., & Mirfendereski, D. (2004). Inflation-indexed securities: bonds, swaps and other derivatives. John Wiley & Sons.
- Wood, P. R. (1997). International loans, bonds, and securities regulation. Sweet & Maxwell.
- Farhi, E., & Tirole, J. (2008). Competing liquidities: corporate securities, real bonds and bubbles (No. w13955). National Bureau of Economic Research.
Author: Dominika Kubik