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Bond Defined
It is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon). Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity) longer than one year.
A bond is just a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender and the coupon to the interest.
Debt securities with a maturity shorter than one year are typically bills, certificates of deposit or commercial paper, and considered money market instruments.
Traditionally, the U.S. Treasury uses the word bond only for their issues with a maturity longer than ten years, and calls issues between one and ten year notes. Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Market participants use bonds normally for large issues offered to a wide public, and notes rather for smaller issues originally sold to a limited number of investors. There are no clear demarcations.
Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds have a definite lifespan, their maturity, whereas stocks may be held indefinitely. An exception is a console bond, which is a perpetuity.
Features of bonds
The most important features of a bond are:
nominal, principal or face amount - the amount over which the issuer pays interest, and which has to be repaid at the end.
issue price - the price at which investors buy the bonds when they are first issued. The net proceeds that the issuer receives, are calculated as the issue price, less the fees for the underwriters, times the nominal amount.
maturity date - the date on which the issuer has to repay the nominal amount. After the maturity date the issuer has no more obligations to the bond holders, as long as all payments have been made of course. The length of time until the maturity date is often referred to as the term or simply 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 even do not mature at all. These are called perpetuities. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
• short term (Bills): maturities up to one year
medium term (Notes): maturities between one and ten years
• long term (Bonds): maturities greater than ten 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 indeed it can be 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.
coupon dates - the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.
callability - Some bonds give the issuer the right to repay the bond before the maturity date on the call dates. 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.
• puttability - Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates.
• call dates and put dates - the dates on which callable and puttable bonds can be redeemed early.
There are three 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.
indenture - a document specifying the rights of bond holders. In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bond holders.
Types of bonds
Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
Floating rate notes (FRN's) have a coupon that is linked to a money market index, such as LIBOR or EURIBOR, for example three months USD LIBOR +0.20%. The coupon is then reset periodically, normally every three months.
Convertible bonds can be converted, on the maturity date, into another kind of security, usually common stock in the company that issued the bonds.
High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are relatively risky, investors expect to earn a higher yield, hence the name high yield bonds. Those market participants that want to emphasize the risky nature of the bonds, also call them junk bonds.
Zero coupon bonds do not pay any interest. They trade at a substantial discount from par. The bond holder receives the full principal amount on the maturity date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. Government. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently.
Inflation linked bonds, in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980's. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. Government.
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), collateralized mortgage obligations (CMO) and collateralized debt obligations (CDO).
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 the expectation that you get paid back is lower, the risk is higher. Therefore, subordinated bonds have a lower credit rating then 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. 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.
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