Introduction to Bonds Market and Instruments

INTRODUCTION TO BONDS MARKET AND INSTRUMENTS

(EXCLUDING VALUATION)

Companies need capital to carry out various expansionary activities. So what is the source of capital for a company? The answer is: Equity and Debt. As we know, equity is in the form of shares or stocks the company issues and the shareholder becomes a part owner of the company and receives dividend on the shares as decided by the company’s policy. But this is not the only way a company can raise money from the general public. The alternate way is: The company issues Bonds. Not only the companies need capital, the government also needs money to fund various infrastructure projects and carry out other welfare schemes. The government also raises money from the general public by issuing bonds.

So, what instrument is a bond exactly?

 A bond is a loan that the bondholder gives to the bond issuers. As described above, corporates, government and municipalities issues bonds.

As bond is a loan, it is the capital that is raised by debt. And the same as we pay interest on the loans we get, the bond issuer also pays interest periodically and pays the principal amount at a stated time. The time at which the principal is repaid is known as the maturity. The rate of interest is called the coupon rate. The amount borrowed is known as the face value or par value.

We can understand the concept clearly by the following example:

Suppose a corporation wants to build a new manufacturing plant for $1 million and decides to issue a bond offering to help pay for the plant. The corporation might decide to sell 1,000 bonds to investors for $1,000 each. In this case, the “face value” of each bond is $1,000. The corporation – now referred to as the bond issuer − determines an annual interest rate, known as the coupon, and a timeframe within which it will repay the principal, or the $1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. The issuer may decide to sell five-year bonds with an annual coupon of 5%. At the end of five years, the bond reaches maturity and the corporation repays the $1,000 face value to each bondholder.

Bonds are traded in secondary market after they are issued. They can be traded publicly over exchanges or through large broker-dealers acting on their clients’ behalf. When a bond trades above its face value, it is said to be selling at a premium and when it is trading below its face value, it is said to be selling at a discount.

By purchasing bonds, the bondholders become creditors to the corporation or government (bond issuer). The primary advantage a creditor has is higher claim on assets than shareholders i.e., in case of bankruptcy; a bondholder will be paid before the shareholder. However, the bondholders do not have any claim over the profits that the company makes. The bondholders will only get the principal plus interest.

How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A $1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many more factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period relative to a 5-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk. 

Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services like Moody’s, S&P, Fitch etc. assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer. The bonds issued by the government are the safest.