We usually come across the term “bond” when it comes to economic or financial matters. Most of the time, the term is used during some economic transaction by corporate or related to some governmental investment – usually seen as some sort of capital that aids in a transaction. This article is aimed at making our readers understand what exactly a bond means in finance.
According to the Oxford dictionary, especially in terms of finance, a bond is a legal document or an agreement, usually given by the government or a company, which states that the institution is to pay a certain amount as an interest for the sum of money a person has lent to the particular institution. It can be considered as an instrument of an obligation of the issuer to its holder. In simple terms, it is a kind of loan, which is given to a company or a government, unlike the loans usually given by the government or a company. Though there are several types of bonds, two most used and the common types of bonds include the corporate bond and the municipal bonds.
How does it work?
A bond can be considered as a security for a debt, in which the issuer of the bond owes a particular sum amount of money to the bondholder, which has to be paid within a particular amount of time. The amount and the time period of a bond depend on both the parties – the issuer and the holder – and it varies as per the mutually agreed terms. The indebted institution, which is either the government or a company, is to pay back the loan through interests, also known as coupons, or to return the whole principal amount, along with interest after a specific period of time. In financial terms, the period of time when the bond has come to an end, and the amount has to be paid is known as the maturity date.
Features of the Agreement
Legally, since the bond is an agreement, there are certain characteristic features which are common to each and every bond. It contains the details of the loan which has been paid by the investor to the borrower. For instance, the most important information mentioned in the bond is –
- Who is the issuer of the bond – the state, sovereign governments, municipalities, or a company?
- Who is the lender or the bondholder?
- What amount has been paid by the lender?
- What is the maturity date of the bond?
- What amount has to be paid back by the bond issuer or borrower?
- Through what means will it be paid back?
- Acknowledgment and sign of both of the parties.
Basic Characteristics of a Bond
There are some basic characteristics of bonds that have to be kept in mind.
A tradeable asset is an asset that can be sold again for a profit. A bond is treated as a secured tradeable asset, and the ownership of it can be sold for a profit margin, therefore, also making it a highly liquid asset in the market.
Fixed Income Instrument
A bond is treated as a fixed income instrument. To understand it in simple terms, it means that a bond usually gives the bondholder a fixed amount of money, which was decided to be paid as an instrument in the agreement. Though it is one of the traditional characteristics of a bond, today, variable floating interests are also paid through a bond, and this depends on the kind of agreement.
A number of people tend to ignore or fail to acknowledge credit rating as an important characteristic factor of a bond. Credit ratings of a company or government are important to consider since it affects the price of the bond, interest (coupon) rate, and also the investment amount by the lenders. Companies with high credit ratings have a good reputation and low risk of being a defaulter, while on the other hand, low credit ratings indicate a high risk of being a defaulter in the market. There are several trusted agencies and online websites which release the credit ratings of companies and agencies who trade bonds. Taking it into consideration, the high-quality bonds issued by high credit ranking companies or government are called Investment Grade Bonds, while the average and low credit rating bonds are called High Yielders or Junk Bonds.
The price of a bond is inversely correlated with the interest rates. It means that if the rate of interest of the bond is high, then the price of the bond is low, and vice versa. Moreover, other factors that influence the price of the bond include the credit quality of the borrower and also the time period (maturity time period) of the bond. To explain it in a more simple way, bond issuers who have a low credit quality pay more interest because they are at a greater risk of being defaulters. Since the lenders are also making an investing risk by giving them credit, interest rates are kept higher to ensure low risks for the bondholder.
A bond can be considered as a tool of financial security by the bondholder since it gives a fixed amount of interest or the principal amount back to the creditor or bondholder. Moreover, being the creditor, a bondholder gets priority over stockholders of a particular company – therefore, the principal amount is always returned.
Why are Bonds Issued?
There are times when banks are unable, incapable, or either not allowed issuing the sum of amount as required by a company, state, government, or any governmental institute. During such a moment, these institutions or companies have to depend on independent lenders for the sum amount. These lenders can either come together as one lending party or one individual can lend the whole amount.
There are many ways how bonds can be issued – either publicly, OTC (Over the Counter), or privately between the lender and the borrower. Bonds become a legal agreement between the lender (bondholder) and the borrower (bond issuer). Once the bond has been issued, a particular interest or the whole principal amount has to be paid back to the bondholder. Since bonds are liquid tradeable assets, the company or government has to pay it to the person or trust who currently holds the bond.
Types of Bonds
As mentioned above, there are several types of bonds available in the market. Some of them are as follows:
Corporate bonds are one of the most common bonds available in the market, and maximum bondholders hold this type of bond. As the name suggests, these types of bonds are specifically issued by companies. It would be interesting to note that companies are the highest issuers of bonds in the market since they require or accept high amounts that banks do not or cannot provide. These bonds are usually of high value and one reason why they seek loans in returns of bonds because they get a lot of advantage in the market by providing bonds instead of taking loans.
As the name mentions again, municipal bonds are usually issued by the municipalities or state. Though municipalities or states have reserved revenue and a budget to go ahead with their state business, sometimes, they depend on independent individuals who would invest in them. Municipalities or state usually issues bonds whenever they plan on starting a new project and need a huge amount as investments. Similar to the companies, instead of taking loans from banks, they find it beneficial to take in investments from the individuals themselves. Depending on the municipalities as well as the state policies, some municipal bonds even provide tax-free interest income for their lenders or bondholders, who wish to invest in their project plans.
Government bonds are slightly different from municipal bonds since they are issued by the Treasury. Government bonds have a time period or maturity period for a long – which is usually more than ten years. Moreover, these bonds are issued by the national government and can also be known as sovereign debt, since it is the sovereign who has taken the loan from the individual. Investing in government bonds are known to have low risks before maturity since the government usually ensures back the principal amount. These bonds also have a high value in the market, making them more profitable in the secondary market.
Unlike the municipal and government bonds, agency bonds are usually issued by a particular governmental affiliated agency. These agencies can be totally independent and autonomous, or they can be partly overlooked by the government. Though agency bonds are really less in the market, they are also worth investing from the viewpoint of an investor, who has a profitable value in the secondary market.
In simple terms, bonds are a legal agreement which acknowledges a loan taken by a particular party. In contrast to the general loans which are issued by the banks to individuals or companies, bonds acknowledge the kind of loans which are taken by a corporation, company, municipality, state or the nation from a particular individual or group of individuals who are willing to invest. Similar to a loan, these companies or institutions provide interest to its lenders or the whole principal amount after a long period of time.