Bonds are debt papers that represent borrowing or loans. 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. Different types of bonds must be known for being a business student. The money borrowing party issues bonds to the lending party (Bondholder) in exchange for cash. These borrowers and lenders may be companies, individual persons, or governments. Therefore the bonds are issued for a fixed amount of cash and a fixed period.
The bondholder purchases bonds and pays a certain amount of money to the borrowing party. He will receive fixed 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 the government) Term Finance Certificate (TFC issued by public listed companies) and T-Bill (Issued by the government) etc.
Example of Bonds
A manufacturing company needs cash for the 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 the same face value of Rs 1,000 for two years duration and offers a 12% p.a. coupon interest rate on the principal amount to the bondholder for 2 years. The face value and coupon interest rate are printed on the bond. Now the bondholder will receive a regular fixed 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 fixed income to the bondholders. Since 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 a basis for the calculation of the value of the bond. The holder of the bond receives fixed interest payments as well as his principal amount at the maturity date of the bond. These cash flows emerged from the cash flows generated by the bond issuing party (company) through the sale of its products.
Characteristics of Bonds
Different countries have different forms of bonds in Pakistan bonds are in the form of term finance certificates (TFCs). The trading of these bonds is made on three stock exchanges in Pakistan. It is a 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 periods 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.
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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 companies changes from time to time and therefore the market value or price of the bond.
Therefore also fluctuates based on the demand and 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. So the bond issuing company must pay its bondholders 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 and Legal Points
Bonds have certain numerical and legal points which are as follows:
Maturity or Tenure of Life
The maturity or tenure of the life of the bond is measured in years. There is a maturity date of every bond on which the issuer of the bond will have to return all the principal amount of the bond besides the payment of interest coupon income. Bonds have a 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 to the bondholder on the maturity of the bond. Besides this, the bond also has market value or intrinsic value.
Coupon Interest Rate
The coupon rate is the percentage of the face value of the bond which is paid as interest to the bondholder. Thus coupon rate is also fixed and 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 a monthly, quarterly, semi-annually, or annual basis.
There is a long legal agreement between the issuer of the bond and the trustee (mostly a bank that serves as a representative of the bondholder) of the bond. This legal indenture secures bondholders from mismanagement by the issuer of the bond and default etc.
Claims on Assets and Income
In case the bond issuing company closes down, the bondholders have the first claim on the assets of the company. Also, the bondholders 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 bondholder 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 and subordinate bonds are not backed by real assets instead these are secured by personal and corporate guarantees and their security and value are associated with the forecasted future cash inflows of the company.
The bond issuer has the right and option to call back or redeem or retire the bond before its maturity date by paying off the principal amount to the bondholder. In case dropping of market interest rates, the bond issuer mostly calls back the bondholders and pays them the principal amount, and again reissues new bonds with a lower interest rate.
Bonds Ratings and Risks
Many rating agencies rate the bands according to the riskiness of the bonds. For example, the international rating agencies are Moody’s, and 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 in 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
- The small size of business
- Large variations in income
- Country and foreign exchange rate risk
International Bond Rating Scale (starting from least risky or best) is as follows.
AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Also positive is good, and negative is worse. So B+ is better than B. And B- is worse than B.
Types of Bonds
Types of bonds are many and a business student must know these types of bonds along with their value, maturity, characteristics, and investment in bonds. Below are the different types of bonds discussed:
- Mortgage Bonds
- Subordinated Debt and General Credit
- Floating rate Bonds
- Zero Bonds and Low Coupon Bonds
- Junk Bonds and High Yield Bonds
- Convertible Bonds
Mortgage bonds are general kinds of bonds that are secured by some real asset.
Subordinated Debt and General Credit
These bonds are of a little lower in rank and claim as compared to mortgage bonds.
This kind of bond is not backed by any real assets. There may be some kind of personal or corporate security behind these bonds but they are much riskier.
Floating Rate Bond
This kind of bond bears a yield that can rise or fall within a certain range based on fluctuations in the market. In the housing bond market, floating rate bonds are used.
Eurobonds are issued from a foreign country like England.
Zero Bonds and Low Coupon Bonds
These bonds do not offer regular interest payments to the bondholder. Also besides this, the bond issuer does not have the right to call back these bonds.
Junk Bonds and High Yield Bonds
Some corporations are smaller in size and also there is no standard operating track record for them. So these are closed to be regarded as a speculative grades. Moreover, these corporations issue highly risky junk bonds and S&P rated these bonds below BB.
A bond that has the feature to be converted into the common stock of the company is considered a convertible bond. This kind of bond among different types of bonds can be issued by a company and later it can be converted into shares of the company at some predetermined ratio e.g. in the 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 the stock of the company and obtain capital gains. Hence in case of bankruptcy of the company, these types of bonds are considered normal bonds and so the bond holder can get back at least some portion of the money.
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