An Overview of Bonds

Bonds are viewed as a relatively safer investment option as compared to equity, as it is basically a form of debt which makes the borrower legally obligated to repay it. In addition the ratings attached to bonds provide a good overview of the risk attached with a particular bond issue. Also, bonds are relatively more stable as compared to other investment avenues like equity while providing a good balance of flexibility and returns.

In this post we will look into bonds understand the basic concepts about bonds.

What are Bonds?

A bond is basically a type of debt instrument used by corporations or governments to raise funds. A bond requires the issuer (or the debtor/borrower) to repay to the lender/investor the amount borrowed plus interest over a specified period of time. A typical bond issue specifies a fixed date on which the borrowed/principal amount is due, also known as the maturity date and the contractual amount of interest i.e., the coupon rate which is typically paid on a bi-annual basis. If the issuer does not default or redeem the issue on a prior date, the entity holding the bond is assured of a known cash flow pattern. 

Types of Bonds

Bonds can be classified into different categories based on different classification factors:

Term of a Bond

1. Short Term Bonds - Bonds with maturity period below 5 years are considered short term bonds.
2. Intermediate Term Bonds - Bonds with maturity period between 5 and 12 years come under this category.
3. Long Term Bonds - Bonds with maturity period more than 12 years are classified as long term bonds.

There is an ongoing debate on the term classification of bonds, however these time periods are generally accepted.

Interest Paid

1. Normal Coupon Bonds - Normal Coupon Bonds pay a predetermined interest or coupon at regular intervals, normally semi-annually, during the bond's lifespan.
2. Zero-Coupon Bonds - Zero Coupon Bonds do not pay any coupon or interest but trade at a deep discount to their par value. The earning of the lender comes from the difference between the discounted purchasing price and the par value of the bond to be repaid at maturity.
3. Floating-rate Bonds - Floating rate bonds are issues where the coupon rates reset periodically based on a formula. This formula, known as the coupon reset formula is generally of the form: reference date + quoted margin. The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. 
4. Deferred Coupon Bonds - In these bonds the interest is not paid out at regular intervals but the interest stated on issue accrues over the term of the bond and is paid in a lump sum amount on maturity.

Issuer of the Bond

1. Government Bond - These are bonds issued by the central government of a country. They can long or short term bonds and are the most secure bonds in the market. They are generally issued as a tool of the monetary policy or to raise funds for projects or investments. For e.g. U.S. Treasury Bills.
2. Corporate/Private Bond - These bonds are issued by corporations, companies or businesses as a way to raise capital.
3. Municipal Bond - These bonds are issued by local, state or central governments in order to finance capital expenditure.

There are also other types of bonds like convertible bonds, callable bonds, puttable bonds, etc. However, the above are the main types of bonds.

Main Characteristics of a Bond

1. Face Value / Par Value / Principal Value - It is the amount that the bond issuer has promised to pay to the bond holder at the time of maturity.
2. Term to Maturity - The term to maturity of a bond is the number of years over which the issuer has promised to meet the conditions of the obligation. The maturity of a bond refers to the date that the debt will cease to exist, at which time the issuer will redeem the bond by paying the outstanding principal.
3. Coupon Rate - The coupon rate is the rate at which the bond issuer will pay the interest on the face value of the bond.
4. Coupon Dates - The coupon dates are the dates/intervals in which the interest payment will be made by the bond issuer. In general, the interest is paid on a semi-annual basis.
5. Maturity Date - The date on which the bond will mature, and the bond issuer will repay the amount borrowed to the bond holders. 
6. Issue Price - The price at which the bond is issued. Generally the bond is issued at par or at the face value but at times can also be issued at a discount or premium.