Bonds are debt papers that represent borrowing or loan. These are a kind of direct claim security whose value is secured by some real assets which are owned by the issuer of that security. The money borrowing party issues bond to the lending party (Bondholder) in exchange of cash. These borrower & lender may be companies, individual persons or governments. The bonds are issued for fix amount of cash & for fix period of time. The bondholder purchases bond and pays certain amount of money to the borrowing party. He will receive fix regular interest payments on his lending money till the maturity of the bond. At the maturity date the borrower gets back his principal amount as well. Examples of bonds are Defense Saving Certificate (DSC issued by government) Term Finance Certificate (TFC issued by public listed companies) & T-Bill (Issued by government) etc.
Example of Bonds
A manufacturing company needs cash for extension of the business. The management has decided to raise capital of 2 million in the form of debt. It issues 20 thousand bonds of same face value of Rs 1,000 for two years duration and offers 12% p.a. coupon interest rate on the principal amount to the bond holder for 2 years. The face value & coupon interest rate are printed on the bond. Now the bond holder will receive regular fix income of 12% of the face value of the bond for two years. When the bonds are matured after two years, the bondholder will get back his entire principal amount from that manufacturing company. In this way the manufacturing company raises capital through debt in the form of bonds. The manufacturing company is legally bound to pay regular fix income to the bond holders because bonds are generally secured by some real assets which must be owned by the issuer of the bond.
Value of Bond
The cash flows associated with the bond provide basis for calculation of the value of the bond. The holder of the bond receives fix interest payments as well as his principal amount at maturity date of bond. These cash flows emerged from the cash flows generated by the bond issuing party (company) through sale of its products.
Characteristics of Bonds
Different countries have different forms of bonds like in Pakistan bonds are in the form of term finance certificate (TFCs). The trading of these bonds is made on three stock exchanges of Pakistan. It is very common fact that bonds are traded in the stock markets. In Pakistan the face value of each TFC (bond) is generally Rs 1,000 but it can be changed. The life of bonds is fixed for certain period of time e.g. six months, one year, three years, five years etc. The party (public company, private, individuals, government etc) that needs to borrow money can issue bonds.
Each bond has a face value or par value which is written on it. The face value is fixed but the bonds are normally traded in the market on market value or price. The financial health of bond issuing company changes from time to time and therefore the market value or price of the bond also fluctuates on the basis of demand & supply of the bond and the perception of investors. The changes in the rate of interest seriously affect the bond price or market value in the market. The bond issuing company must pay its bond holders otherwise the company is compelled to close down.
Position in Balance Sheet
The issuing company mentioned their issued bonds on the liabilities side of their balance sheet as long term liabilities whereas the company investing in bonds shows the purchased bonds on the assets side of their balance sheet under the head of marketable securities.
Numerical & Legal Points
Bonds have certain numerical & legal points which are as follow
- Maturity or tenure of life
The maturity or tenure of life of bond is measured in years. There is a maturity date of every bond on which the issuer of the bond will have to return back all the principal amount of the bond besides the payment of interest coupon income. Bonds have life of 6 months, 1 year, 3 years, 5 years, 10 years etc.
- Par value or Face Value
The par value or face value of the bond is fixed and it is imprinted on the bond paper. The face value must be returned back to the bond holder on the maturity of the bond. Besides this the bond also has market value or intrinsic value.
- Coupon Interest Rate
Coupon rate is the percentage of face value of the bond which is paid as an interest to the bond holder. Coupon rate is also fixed & is not affected by the changes in the market price of the bond. Cash receipt = Coupon Rate x Par Value. The coupon receipts can be paid out on monthly, quarterly, semi-annually or annual basis.
There is long legal agreement between the issuer of the bond and the trustee (mostly bank which serves as representative of the bond holder) of the bond. This legal indenture secures bond holders from the mis-management by the issuer of the bond & default etc.
- Claims on Assets & Income
In case the bond issuing company closes down, the bond holders have first claim on assets of company. Also the bond holders are paid first from the income of the company before the distribution of net income in form of dividends to the shareholders. If the bond issuing company is not able to pay interest payment to the bond holder then the bond holder can legally compel the company to close down as bankrupt.
The mortgage bonds are secured by some real assets (building, machinery, land etc) and the value of underlying assets is more than the value of the bond issued. Debentures & subordinate bonds are not backed by real assets but instead these are secured by personal & corporate guarantees and their security & value is associated with the forecasted future cash inflows of the company.
- Call Provision
The bond issuer have right & option to call back or redeem or retire the bond before its maturity date by paying off the principal amount to the bond holder. In case dropping of market interest rates, the bond issuer mostly call back the bond holders and pays them principle amount and again reissue new bonds with lower interest rate.
Bonds Ratings & Risks
There are many rating agencies that rate the bands according to the riskiness of the bonds. For example the international rating agencies are Moody’s, S&P. There are certain country based rating agencies too. Like in Pakistan PACRA and VIS are two rating agencies that rate the bonds of companies of Pakistan.
The rating of the bonds is based on the future risk potential of the bond issuing company. Bond risk increases due to the following reasons.
- Excessive borrowing or debt
- Operating losses
- Small size of business
- Large variations in income
- Country & foreign exchange rate risk
International Bond Rating Scale (starting from least risky or best) is as follow.
AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Also +ive is good and –ive is worse. So B+ is better than B. And B- is worse than B.
Different Bond Types
Below are the different important bond types that must b in your mind as a business student.
- Mortgage Bonds
- Subordinated Debt & General Credit
- Floating rate Bonds
- Zero Bonds & Low Coupon Bonds
- Junk Bonds & High Yield Bonds
- Convertible Bonds
Mortgage bonds are general kind of bonds which are secured by some real asset.
Subordinated Debt & General Credit:
These bonds are of little lower in rank & claim as compared to mortgage bonds.
This kind of bonds is not backed by any real assets. There may be some kind of personal or corporate security behind these bonds but they are much risky.
Floating Rate Bond:
This kind of bonds bears a yield that can rise or fall within certain range on the basis of fluctuations in the market. In the housing bond market, floating rate bond is used.
Eurobonds are issued from a foreign country like England.
Zero Bonds & Low Coupon Bonds:
These bonds do not offer regular interest payments to the bond holder. Also besides this, the bond issuer does not have the right to call back these bonds.
Junk Bonds & High Yield Bonds:
There are corporations which are smaller in size and also there is no standard operating track record in them. So these are closed to be regarded speculative grade. These corporations issue junk bonds which are highly risky and S&P rated these bonds below BB.
The bond which has feature to be converted into the common stock of the company is considered as convertible bond. This kind of bond can be issued by a company and later it can be converted into shares of the company at some predetermined ratio e.g. in case of 30:1, the holder of one convertible bond (Face value 1,000) can get 40 shares of the common stock of the company. The yield offered by convertible bonds is lower as compared to other bonds because the bond holder can have the option to convert that bond into stock of company & obtains capital gains. In case of bankruptcy of the company, these bonds are considered as normal bonds and so the bond holder can get back at least some portion of money.