Bond (finance)

Overview

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor; which usually consists of repaying the principal (the amount borrowed) of the bond at the maturity date, as well as interest (called the coupon) over a specified amount of time. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure. Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in a company (i.e. they are owners), whereas bondholders have a creditor stake in a company (i.e. they are lenders). As creditors, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors, in the event of bankruptcy. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks typically remain outstanding indefinitely. An exception is an irredeemable bond, which is a perpetuity, that is, a bond with no maturity. Certificates of deposit (CDs) or short-term commercial paper are classified as money market instruments and not bonds: the main difference is the length of the term of the instrument. The most common forms include municipal, corporate and government bonds. Very often the bond is negotiable, that is, the ownership of the instrument can be transferred in the secondary market. This means that once the transfer agents at the bank medallion-stamp the bond, it is highly liquid on the secondary market. The price of a bond in the secondary market may differ substantially from the principal due to various factors in bond valuation. Bonds are often identified by their international securities identification number, or ISIN, which is a 12-digit alphanumeric code that uniquely identifies debt securities.

Etymology

In English, the word "bond" relates to the etymology of "bind". The use of the word "bond" in this sense of an "instrument binding one to pay a sum to another" dates from at least the 1590s.

Issuance

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process for issuing bonds is through underwriting. When a bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the entire issue of bonds from the issuer and resell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The bookrunner is listed first among all underwriters participating in the issuance in the tombstone ads commonly used to announce bonds to the public. The bookrunners' willingness to underwrite must be discussed prior to any decision on the terms of the bond issue as there may be limited demand for the bonds. In contrast, government bonds are usually issued in an auction. In some cases, both members of the public and banks may bid for bonds. In other cases, only market makers may bid for bonds. The overall rate of return on the bond depends on both the terms of the bond and the price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is determined by the market. In the case of an underwritten bond, the underwriters will charge a fee for underwriting. An alternative process for bond issuance, which is commonly used for smaller issues and avoids this cost, is the private placement bond. Bonds sold directly to buyers may not be tradeable in the bond market. Historically, an alternative practice of issuance was for the borrowing government authority to issue bonds over a period of time, usually at a fixed price, with volumes sold on a particular day dependent on market conditions. This was called a tap issue or bond tap.

Principal

Nominal, principal, par, or face amount is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to the performance of particular assets.

Maturity

The issuer is obligated to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or 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 shorter than 30 years. Some bonds have been issued with terms of 50 years or more, and historically there have been some issues with no maturity date (irredeemable). In the market for United States Treasury securities, there are four categories of bond maturities:

short term (bills): maturities under one year; medium term (notes): maturities between one and ten years; long term (bonds): maturities between ten and thirty years; perpetual: no maturity period.

Coupon

The coupon is the interest rate that the issuer pays to the holder. For fixed rate bonds, the coupon is fixed throughout the life of the bond. For floating rate notes, the coupon varies throughout the life of the bond and is based on the movement of a money market reference rate (historically this was generally LIBOR, but with its discontinuation the market reference rate has transitioned to SOFR). Historically, coupons were physical attachments to the paper bond certificates, with each coupon representing an interest payment. On the interest due date, the bondholder would hand in the coupon to a bank in exchange for the interest payment. Today, interest payments are almost always paid electronically. Interest can be paid at different frequencies: generally semi-annual (every six months) or annual.

Yield

The yield is the rate of return received from investing in the bond. It usually refers to one of the following:

The current yield, or running yield: the annual interest payment divided by the current market price of the bond (often the clean price). The yield to maturity (or redemption yield, as it is termed in the United Kingdom) is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the capital redemption on schedule. It is a more useful measure of the return on a bond than current yield because it takes into account the present value of future interest payments and principal repaid at maturity. The yield to maturity or redemption yield calculated at the time of purchase is not necessarily the return the investor will actually earn, as finance scholars Dr. Annette Thau and Dr. Frank Fabozzi have noted. The yield to maturity will be realized only under certain conditions, including 1) all interest payments are reinvested rather than spent, and 2) all interest payments are reinvested at the yield to maturity calculated at the time the bond is purchased. This distinction may not be a concern to bond buyers who intend to spend rather than reinvest the coupon payments, such as those practicing asset/liability matching strategies.

Credit quality

The quality of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. In other words, credit quality tells investors how likely the borrower is going to default. This will depend on a wide range of factors. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.

Market price

The market price of a tradable bond will be influenced, among other factors, by the amounts, currency, and timing of the interest payments and capital repayment due, the quality of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets. The price can be quoted as clean or dirty. "Dirty" includes the present value of all future cash flows, including accrued interest, and is most often used in Europe. "Clean" does not include accrued interest, and is most often used in the U.S. The issue price at which investors buy the bonds when they are first issued will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. The market price of the bond will vary over its life: it may trade at a premium (above par, usually because market interest rates have fallen since issue), or at a discount (price below par, if market rates have risen or there is a high probability of default on the bond).

Others

Indentures and Covenants—An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders. Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer: Callability—Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. 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 holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. These are referred to as retractable or putable bonds. Call dates and put dates—the dates on which callable and putable bonds can be redeemed early. There are four 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. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of a deceased bondholder to put (sell) the bond back to the issuer at face value in the event of the bondholder's death or legal incapacitation. This is also known as a "survivor's option". Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date; if not, the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in the open market, then return them to trustees.

Types

Bonds can be categorised in several ways, such as the type of issuer, the currency, the term of the bond (length of time to maturity) and the conditions applying to the bond. The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond:

The nature of the issuer and the security offered

The nature of the issuer will affect the security (certainty of receiving the contracted payments) offered by the bond, and sometimes the tax treatment.

Government bonds, often also called treasury bonds, are issued by a sovereign national government. Some countries have repeatedly defaulted on their government bonds, while some other treasury bonds have been treated as risk-free and not exposed to default risk. Risk-free bonds are the safest bonds, with the lowest interest rate. A Treasury bond is backed by the "full faith and credit" of the relevant government. However, in reality most or all government bonds do carry some residual risk. This is indicated by the award by rating agencies of a rating below the top rating, bonds issued by different national governments, such as various member states of the European Union, all denominated in Euros, offering different market yields reflecting their different risks. A supranational bond, also known as a "supra", is issued by a supranational organisation like the World Bank. They have a very good credit rating, similar to that on national government bonds. A municipal bond issued by a local authority or subdivision within a country, for example a city or a federal state. These will to varying degrees carry the backing of the national government. In the United States, such bonds are exempt from certain taxes. For example, Build America Bonds (BABs) are a form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional US municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the US state where it is issued. Generally, BABs offer significantly higher yields than standard municipal bonds. A revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse", meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues. A War bond is a bond issued by a government to fund military operations and other expenditure during wartime. It will often have a low return rate, and so can be bought due to a lack of opportunities or patriotism. Corporate bonds are issued by corporations. High-yield bonds (junk bonds) are bonds that are rated below investment grade by the credit rating agencies, because they are uncertain that the issuer will be able or willing to pay the scheduled interest payments and/or redeem the bond at maturity. As these bonds are much riskier than investment grade bonds, investors expect to earn a much higher yield. A climate bond is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation- or adaptation-related projects or programmes. For example, in 2021 the UK government started to issue "green bonds". 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 (MBSs), collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs). Covered bonds are backed by cash flows from mortgages or public sector assets. Unlike asset-backed securities, the assets for such bonds remain on the issuer's balance sheet. 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 are called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than 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. Social impact bonds are an agreement for public sector entities to pay back private investors after meeting verified improved social outcome goals that result in public sector savings from innovative social program pilot projects.