A bond is a debt instrument that is a security sold into the open market. This is issued by corporations and governments as a way to raise money. Hence, investors are loaning money to these institutions. This is done for a set period of time, as denoted by the financial instrument. There is also a set return which is spelled out on the bond itself.
Some types of bonds are:
The issuer is debtor that provides the holder to provide cash flow. Payments are made that cover the interest, called coupon, at certain intervals throughout the life of the bond. At maturity, the principal is repaid which is the original amount put into the purchase of the bond.
Another way of thinking about it is that a bond is an I.O.U. between the lender and borrower that includes the details of the loan and the payments.
Bonds are the most common security along with stocks. The difference between the two is that shareholders have an equity stake since they are owners. Bond holders are creditors meaning they have no ownership in the entity. However, they do have priority over stockholders in a bankruptcy.
Why Issue Bonds
Entities issue bonds as a way to borrow on projects that are too expensive to make a single payment. For example, a municipality might issue a bond for a parking garage or a company would borrow to build a factory.
Governments like this since they do not have to budget for an entire project. Instead, it can simply allocate money for the payments along with planning on the redemption when the maturity date arrives.
Bonds is funding that bypasses the banks. Here entities are tapping the debt markets. These are no bank loans by depository institutions which results in the expansion of the money supply. Bonds are sold into existing markets, paid for with existing currency (such as US dollar or EURO).
Unlike a car loan or a mortgage, a government’s borrowing is structured differently. Instead of establishing a repayment schedule based on a single interest rate and single maturity date, when a government issues bonds, the repayment schedule is based on multiple maturity dates with different interest rates. Thus, at any given time, the government may owe money to thousands of different individuals, businesses, or governments holding its bonds and not just to a single lender.
Governments (and municipalities) use bonds to fund budget deficits or manage the cash flow for a specific project. Corporations turn to bonds in an effort to grow their business, in most cases.
Zombie corporations are those who use debt to keep paying their ongoing operations, including the serving costs associated with previous debt taken out.
Bond Characteristics
Both private businesses and government entities issue bonds that share common characteristics:
The issuer is the entity borrowing money, such as a state or local government.
The bond’s par or face value is the amount of money that will be repaid at the bond’s maturity date. Most municipal bonds are issued in multiples of $5,000, requiring a rounding up or down of the amount borrowed. U.S. Treasury bonds are a minimum of $100 denominations (T-Bills are $1,000).
The bond’s coupon or coupon rate is the interest rate that will be paid to the bondholder, often every six months. For example, a $5,000 bond with a 5 percent coupon will pay $250 in interest each year, or $125 every six months.
A bond may involve many investors over its life before it is paid off. When bonds are originally issued or are traded later on the secondary market, they may not sell for their par amount. A bond’s price depends on how its coupon rate compares to current interest rates on the market for similar investments. If a bond’s coupon rate is lower than the market rate, the bond will be less attractive to investors and will sell for less than its par amount, or at a discount.
Bonds are issued through financial institutions. With sovereign debt, these are primary dealers who are approved by the central bank.
Yield
Bonds are fixed income instruments which appeals to investors who seek yield. As opposed to stocks, people who buy bonds know their exact return over the life of the asset. There is no speculation if one is holding the bond to maturity.
When buying on the secondary market, yield is the focus for investors.
As an example, let us a suppose a 5 year, $1,000 muni bond pays $25 per year. That is a coupon of 2.5%. If, however, the bond drops in price, to $500, it still pays the same $25 per year from the issuer. This means the yield is now 5%.
Credit Quality
Bonds have a specific rating based upon the entity issuing them. The general rule of thumb is the worse the rating, the higher rate of interest that needs to be paid. Investors will require a larger return for taking on the added risk.
We need to harken back to the basic idea that a bond buyer is really a lender. Just like banks rate perspective borrowers in terms of creditworthiness and assign them to certain categories.
Wall Street firms provide ratings when an issuance is taking place. The financial statements of the company such as balance sheets and income statements are reviewed. Ultimately the goal is to size up the potential of a corporation repaying the bonds and what level of risk buyers are will to take on.