Bond (finance)

In finance and economics, a bond or debenture is a debt instrument that obligates the issuer to pay to the bondholder the principal (the original amount of the loan) plus interest. Thus, a bond is essentially an I.O.U. (I owe you contract) issued by a private or governmental corporation. The corporation "borrows" the face amount of the bond from its buyer, pays interest on that debt while it is outstanding, and then "redeems" the bond by paying back the debt. A mortgage is a bond secured by real estate.

Bonds are securities but differ from shares of stock in that stock is an ownership interest (termed "equity"), but bonds are merely "debt": Therefore a shareholder is an owner, but a bond-holder is merely a creditor.

Each country sets its own rules for issuing and redeeming short and long-term debt and stock. In the U.S. (for example):

Bonds are long-term loans secured by property rather than short-term loans secured merely by the debtor's promise to pay.

Interest paid to bondholders receives preferential tax treatment compared to dividends paid to shareholders.

In bankruptcy, bondholders are paid before short term creditors (including workers who are owed wages) and all creditors must be paid in full before owners receive anything.

Arguments against bonds

Some theories of economics, notably Islamic economics and green economics, argue that the overall impact of any debt on ecosystems and society is so negative that no bond should have any legal status. These theories are part of a broader category called creditary economics. In these, there is no creditor, only a joint venture partner or investor.

Issuing bonds

Bonds are issued by governments or other public authorities, credit institutions, and companies, and are sold through banks and stock brokers. They enable the issuer to finance long-term investments with external funds. The term total volume refers to the number of individual bonds in a bond issue.

Features of bonds

The most important features of a bond are:

initial value, known as the "par value"
maturity date - Bond maturity tells when the investor should expect to get the principal back and how long she can expect to receive interest payments. Bond maturities range from one year to 30 years. There are three groups of bond maturities:
- Short-term bonds (notes): Maturities of 1-4 years
- Medium-term bonds (notes): Maturities of 5-10 years
- Long-term bonds: Maturities of 10-30 years
the "coupon" or "nominal yield," effectively the interest rate
whether the interest rate is fixed or floating

The rights of a particular bond issue are specified in a written document, usually called an "indenture". 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. Those terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bondholders.

Interest is paid on the first "coupon date" and subsequently on coupon dates at regular intervals, assuming the issuer has the money to make the payments on those dates. If all interest ("coupon") payments have not been made when due, and so are in arrears, the issuer must also pay those back-due amounts when it redeems the bond, in addition to the principal ("face") amount.

The bond may have a "call" provision that allows the issuer to pay back the debt (redeem the bond) before its nominal maturity date. When there is no such provision requiring a holder to let the issuer redeem a bond before its maturity date, the issuer may offer to redeem a bond early, and its holder may accept or reject that offer.

There are three broad categories of callable bonds. A "European callable", one with a European-style contract, can only be called on a certain date. A "Bermudan callable" can be called until a certain date, and a "US" or "American callable" can only be called after a certain date.

Bonds can also carry "put options", which allow the investor to sell the bonds back to the issuer at a date specified when the bonds are sold to the investor.

Types of bond

Bonds are classified according to various categories:

Fixed-rate bonds, where the interest rate remains constant throughout the life of the bond.
Floating-rate bonds, with a variable interest rate that is tied to a benchmark such as a money market index.
Zero-coupon bonds, which do not bear interest, as such, but are sold at a substantial discount from their par value. The bondholder receives the full face value at maturity, and the "spread" between the issue price and redemption price is the bond's yield. (Series E savings bonds from the U.S. government are zero-coupon bonds.) Zero-coupon bonds may be created from normal bonds by finance institutions "stripping" the coupons (the interest part of the bond) from them - that is, they separate the coupons from the principal part of the bond and sell them independently from each other.
Inflation Indexed bonds, in which the principle (or "face" value) is indexed to inflation. TIPS (Treasury Inflation-Protected Securities) and I-bonds are examples of inflation indexed bonds issued by the U.S. government.
Securitized bonds whose interest and principal payments are backed by an underlying cash flow from another asset.

Bonds may be issued by various types of institution:

Sovereign bonds, often called government bonds, are issued by national governments.
Municipal bonds are issued by local governments.
Corporate bonds are issued by companies.
Gilts are bonds issued by the government of the United Kingdom in sterling.
Bunds are bonds issued by the German government.

"Convertible bonds" or "convertible debentures" are those that can be converted into some other kind of securities, usually common stock in the corporation that issued the bonds.

"Subordinated bonds" are those that have a lower priority than other debts of the issuing corporation, so if there is not enough money to pay all the company's debts, the "senior" (higher-priority) bonds are paid first, and the subordinate bonds are paid out of what money, if any, is left.

High-yield bonds (with a correspondingly high risk) are sometimes known as junk bonds.

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. Since these factors are likely to change over time, the market value of a bond can vary after it is issued.

The market price of a bond may include the accrued interest since the last coupon date (some bond markets include accrued interest in the trading price and others add it on explicitly after trading). The price including accrued interest is known as the "flat" or "tel quel price". (See also Accrual bond.)

The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).

Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.

The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

see bond valuation

Investing in bonds

Historically, bonds have been the investment of choice for "widows and orphans", or for certain wealthy nonworking individuals, who depend on a trust fund for income. The trust fund invests its money in government and corporate bonds (among other things), and the twice-yearly interest payments from these bonds are sent to the individuals.

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 higher than dividend payments that the same company would generally choose to pay to its stockholders. 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 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, whereas the company's stock often ends up valueless. However, bonds can be risky:

Bonds incur interest rate risk, meaning they will decrease in value when the generally prevailing interest rate rises. This happens to all bonds, no matter what company or government issues them. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere -- perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds. However, price changes in a bond immediately impacts mutual funds that hold these bonds, and if there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, 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 bond risk is in terms of its duration.

Bonds can become volatile if one of the bond rating agencies like Standard and Poor's or Moody's upgrades or downgrades the credit quality of the issuing company or government. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not impact the bond's interest payments, 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 the United States and many other companies, bondholders are first in line to receive the proceeds of the sale of the assets of a bankrupt company, ahead of unsecured creditors. However, this 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.

Most bonds are callable, meaning 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 at once. 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 rates are falling.