A bond is a debt investment in which an investor (known as the ‘purchaser’) loans funds to a corporation, state or government (the ‘issuer) at either a fixed or variable interest rate for a predetermined period. Also referred to as a fixed income security, a bond represents a debt obligation to the issuer in which the principal amount is repaid to the purchaser at maturity.show more
The existence of bond style trading dates back as far as 2400BC. A stone discovered at Nippur in Mesopotamia (modern Iraq) confirmed early trade and using corn as the currency and the guaranteed payment of grain, the bond guaranteed the reimbursement of the principal and a surety in the event of default.
Funding wars and supporting stock market collapses and amid accelerating growth, fast forward to 2016 and the global bond market is currently estimated at $100-trillion with daily trading volume exceeding $700-billion. Traded on a public exchange or over-the-counter, bonds are sold by the issuer – not to finance wars – but to raise funds typically for capital projects and infrastructure activities.
Issued by a country’s government, a government bond is the promise to repay borrowed funds at a fixed interest rate for a predetermined period. Used to support government spending and depending on expiration time, a government bond can also be known as a ‘bill’ (maturity of less than one-year), a ‘note’ (expiration of between one-to-ten years) or a bond which features a maturity of ten years (or more). Considered a low risk investment, a government bond can be sold by either a federal or state government. Rated by a credit ratings agency who consider a governments default risk to repay debt, governments with a higher rated risk must issue government bonds at a higher interest rate while bonds sold by governments with a low risk threshold (referred to as ‘risk free’) such as Australia, New Zealand and the United States issue bonds at a lower interest rate.
The United States also issue ‘municipal bonds’ (or munis bonds) which are bonds issued by government entities. Municipal bonds may be either ‘obligation bonds’ which are issued to raise capital for expenditure and repaid using taxation revenue or ‘revenue bonds’. Revenue bonds are issued to finance income producing projects and are repaid by the revenue generated from those projects. Investment returns on municipal bonds are free from federal tax obligations and are often non-taxable at both state and local government levels. This offers municipal bonds the advantage of being ‘triple-tax free’.
A corporate bond is a debt obligation issued by corporations to investors for the purpose of raising capital for improvements, expansion, acquisitions or debt refinancing. Corporate bonds are characteristically short term (maturity less than five-years), intermediate (five-to-twelve years) or long term with an expiration of more than twelve years.
Issued at either a fixed or variable interest rate, corporate bonds are often sold at higher yields than government bonds due to increased default risk. Also rated by a credit ratings agency and based on the corporation’s financial strength, bonds issued by a highly rated corporation are referred to as ‘investment grade’ while bonds issued by corporations rated below are known as ‘junk’ or ‘high yield’ bonds.
Corporate bonds may be ‘convertible’, ‘callable’ or ‘putable’. Convertible bonds, typically a lower yielding investment, offers the purchaser the option to convert the issued bond into shares at a defined conversion rate. Investors will exercise this option if the corporation’s share price exceeds the breakeven price (selling price divided by conversion rate).
A callable (or redeemable) bond has the option (but not an obligation) to be redeemed by the issuer prior to maturity, that is – the purchaser’s principal is returned and all future interest payments ceased. A callable bond will be used if the issuer anticipates decreasing interest rates. A putable bond allows the purchaser the option (but not the obligation) to demand early repayment of the principal amount at a date before maturity.
A mortgage bond is a bond secured by a mortgage on a real estate holding and/or physical property such as equipment. Because a mortgage bond is asset protected and in the event of a default, the purchaser holds a claim to the underlying property, a mortgage bond is considered a lower yielding bond with interest payable monthly, quarterly or semi-annually.
Often used to measure the value and benchmark performance of the bond market, a bond index (or bond market index) – using a weighted average – is a composite of government, corporate, high yield and mortgage bonds. Price affected by interest rates, credit rating and maturity dates, investment in a bond index offers investors exposure to segments of the bond market without the difficulties of individually selecting bonds for trade.
As a debt instrument in which an investor (known as the ‘purchaser’) loans funds to a corporation, state or government (the ‘issuer), a bond is issued at either a fixed or variable interest rate (referred to as the ‘coupon rate’) payable at defined times (‘coupon dates’) over the life of the loan – annually, semi-annually, quarterly, monthly etc.
The ‘principal’ (or par value) amount – or the amount on which the issuer pays interest – is repaid to the purchaser at ‘maturity’ (often known as the term or tenor of a bond) and is used to calculate the running or redemption ‘yield’ (the rate of return).
The ‘currency denomination’ of the bond refers to the currency in which the bond issuer issues the bond such as AUD, USA, EURO, YEN etc.
Currently valued at an amount in excess of $100 trillion, the bond market is the world’s largest securities market. Used as a mechanism to provide long-term funding for public and private expenditures, the bond market (also referred to as the debt market or credit market), is comprised of the primary market; where new debt is issued, and the secondary market; where debt securities (including bonds, bills and notes etc) are bought and sold.
Traded publicly through exchanges or over-the-counter, bond market prices (in the secondary market) are determined by price and yield. Always moving in opposite direction to yield, a bond’s price is quotes as a percentage of its’ face value and trades at either a discount, premium or at par value (or face value).
EXAMPLE: If a bond is quoted at 89 in the market, the price is $890 for every $1,000 of face value and therefore is trading at a discount. If price is quoted at 110, the price is $1,100 for $1,000 of face value and is trading at a premium. A bond price of 100 is quoted to be trading at par value.
Issued by a credit rating agency such as Moody’s or Standard & Poor’s, a bond rating is a grade given to a bond to offer guidance to a purchaser as to how creditworthy the issuer is. Indicating an issuers credit quality, the higher the rating, the less likely the risk of default and therefore the lower the interest rate the issuer needs to offer to sell the bond. Conversely, the lower an issued rating, the higher the risk of default and consequently the higher the interest rate the issuer needs to apply to sell the bond.
Expressed as uppercase and lowercase letters to differentiate ratings agencies and ranging from AAA (the highest possible grade) to C, D or even E (the lowest possible rating), a bond rating of BBB (or above) indicates the bond is ‘investment grade”. That is, the bond is relatively low risk. Bond ratings below BBB are considered ‘high yield’ or ‘junk’ bonds suggesting a higher risk of default and consequently, a higher yield.
Bond market transactions primarily involve three key market participants: issuers, underwriters and purchasers.
The bond issuer, primarily comprising of corporations, state and federal governments, sell the bonds to the market as a method of financing their operations.
The underwriters, who are typically operate in the primary market, raise investment capital from investors on behalf of the issuing corporations and governments by selling the bonds.
The bond purchasers, who generally participate in the secondary market, are speculators and hedgers who buy the debt instrument. This group of participants primarily consist of individual investors and investment corporations who trade the bond market for investment yield and trading profits.