Bonds

What are Bonds?

Bonds are a type of debt instrument issued to raise capital. The bond investor (lender) lends money to the bond issuer (the borrower) with the promise to repay the amount at a specific date in the future, called the maturity date. Between the issue date and the maturity date, the bond investor typically receives regular interest payments. This comes with a risk that the issuer will not repay the debt (known as default risk).

Bonds are fixed-income instruments where all payments to bondholders are predefined. In comparison, payments to equity holders vary based on the performance of the stock (usually in the form of dividends).

Another key difference between bondholders and equity holders is that bondholders enjoy a priority claim in the event of bankruptcy. They are essentially “creditors” and have protection from such events. Such protection is not available to equity holders who have a residual claim on the lender’s net assets.

Bonds are tradeable, and many bonds can be traded in the secondary markets. This means investors can sell their bonds to another investor before the maturity date.

Characteristics of Bonds

Here are some important characteristics of any bond.

Issuer

The issuer is the entity borrowing the money and should be the one repaying the money. Who the issuer is determines the credit risk associated with in the bond.

Maturity Date

This is the date at which the bond will be redeemed or repaid. The bondholder will receive their principal (face value) back on the maturity date.

Face Value

This is the amount to be repaid to the bondholder at maturity. The face value is expressed in currencies, for e.g., $1 million. The face value is also known as the notional or principal amount.

Coupon

Coupon is the rate of interest paid to the bondholder (lender) per year. It is expressed as a percentage of the face value and always as a per annum rate, even if the coupons are paid more frequently.

Price

The price is the current market price of the bond. It is expressed in percentage terms (of the face value). For example, if a bond worth 100 is trading at 102%, investors will have to pay 102 to purchase this bond.

Types of Bonds

There are different types of bonds. Bonds can be classified based on the following criteria:

By Issuer

Government bonds are issued by governments and are backed by tax receipts. For developed markets, government bonds are considered “risk-free”. These are defined so as the default risk for a government is assumed to be zero. When investing in government bonds, investors focus on the overall economic environment and credit ratings of the country issuing the bonds.

Corporate bonds are issued by companies and are backed by company cash flows. Corporate bonds come with default risk or the risk of the issuer not repaying the debt. The focus for investors is the creditworthiness of issuing companies i.e. how likely are they to receive their investment with interest.

By Coupon Structure

The majority of bonds are fixed coupon bonds. An example is a 10-year bond where the coupon is fixed at 3% at the time of issuance. This coupon rate will remain unchanged over the bond’s life.

In floating coupon bonds, the coupon rate is not fixed. It is set using a reference rate (such as LIBOR) plus a spread. For example, in a 10-year 6m LIBOR + 0.5% bond, the reference rate is 6m LIBOR. Investors will receive a coupon payment based on the prevailing 6m LIBOR rate plus 0.5%. The formula for coupon payment will remain unchanged over the life of the bond.

Zero-coupon bonds do not pay investors any interest payments between issuance and maturity. Instead, they offer investors a profit upon maturity. An example is a 10-year zero bond issued at a price of 75%. Investors do not receive any interest over the 10-year term. Upon maturity, the investors will receive 100%.

By issuer credit ratings

Issuer credit ratings quantify business and financial risks. Rating agencies, such as Standard & Poor’s (S&P), Moody’s, or Fitch assign credit ratings to issuers of bonds. Based on issuer credit ratings, bonds can be classified as 1) Investment grade and 2) Sub-investment grade. Investment-grade bonds are more creditworthy and have a lower default risk as compared to sub-investment grade bonds.

Bond Pricing Approach

The price of a bond is the sum of the present value of:

• Outstanding coupon payments
• Redemption payment

Coupon bond price = C₁/(1+r)¹ + C₂/(1+r)²+…. + C_n/(1+r)ⁿ + FV /(1+r)ⁿ

Where

C is the coupon amount per period

r is the yield or interest rate per period

FV is the face value

n is the number of periods to maturity

Example: Bond Pricing

Based on the above formula, we calculate the price of a 10-year 3% fixed coupon bond. The face value of this bond is 100, and the interest rate or desired rate of return per period is 4%.

We can calculate the price of this bond using the PV function of Excel.

Excel function = -PV (rate, nper, pmt, [FV])

Where

PV is the present value i.e. the price we are calculating

Rate is the interest rate or desired rate of return, per period

Nper is the number of periods to maturity

PMT is the coupon payments per period

FV (future value) represents the face value of the bond