Key finance concepts: Introduction to Bonds

A bond is a long term debt security, which can be issued by a government, company or even a charity. This post describes the main features of bonds.

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A bond is a debt security for which the term (maturity) of the payments is more than a year. It is a form of borrowing that can be used by any organisation or entity or person who can persuade somebody else to buy their bond. Short term (less than a year) debt securities are usually known as bills.

The word bond has a long history, meaning promise, contract or covenant. In Shakespeare’s play The Merchant of Venice, the money-lender Shylock lends money to a merchant who is waiting for his ships to return, after which he hopes to pay the money back. Shylock’s bond is a contract secured on a pound of the merchant’s flesh. In the play he insists “I want my bond”.

Similarly, it used to be said in the City of London that “my word is my bond”, meaning that a City banker’s oral promise could be entirely relied upon, even without any supporting documentation. (Whether this was true, it did suggest that personal reputation was very important in the days when the City was a fairly small club of people).

So “bond” has a general meaning of promise and trust. But in modern finance, a bond is usually a long term debt contract. We talk of sovereign bonds, corporate bonds and mortgage backed bonds as different types of debt security, having in common the purpose of raising funds for the borrower.

A basic bond

The most common and simple form of bond consists of the following contract: the buyer of the bond (the lender) provides a sum of money (the principal) for a fixed period of time (the maturity), in exchange for payments of money (the coupon) which are usually paid twice a year. At maturity the principal is repaid. All cashflows are nominal (there is no adjustment for price inflation). The bond is defined by just three features:

i) the borrower

ii) the maturity

iii) the coupon.

What would make a person think of buying a bond (i.e. lend the money in exchange for the coupon payments and later return of their money)? As with any financial deal, it would need to be that the expected risk and return made for a satisfactory investment, as judged by the bond investor.

The bond issuer’s identity is very important because it affects the risk. The main risk with any debt is of course that the borrower fails to pay. In the case of a bond the issuer may fail to pay the coupons and/or the return of principal at the end of the bond’s term. So bond investors pay great attention to the creditworthiness of the bond issuer. Credit rating agencies such as Moody’s, Fitch and Standard & Poors provide opinions on thousands of bond issuers, including companies and governments. The higher the credit rating, the more likely it is that the bond issuer will honour the contractual cashflows.

The maturity is a matter of mutual convenience. Most bonds tend to be issued in terms of 3, 5, 10 and occasionally 20 or more years. There are some investors who really value long maturity bonds because their own investment needs are long term. An example is life insurance companies who receive monthly payments from their customers in exchange for the promise to pay the customers’ dependants a lump sum of money if they die. Life insurance companies have a very good idea of when (on average) their customers will die and buy bonds that will mature at the time when they expect to need the money. So they are quite happy to buy bonds with 10, 20 and even 30 year maturities.

From the issuer point of view, the benefit of a long maturity bond is that it means the funding is secure for a long time. A short term bond has to be repaid when it matures and often that is done by issuing a new bond. But if the market has become more difficult at that time then the issuer may find it hard to issue the new bond to pay off the principal on the old one. If the bond doesn’t mature for many years then the problem is deferred.

On the other hand, a long maturity bond locks the issuer into a certain cost of finance. If market conditions change and finance gets cheaper, the issuer may regret issuing a long term bond because it lacks the chance to borrow in the market on the new, cheaper terms. One way of managing this risk is to add to the bond an option for the issuer to compulsorily buy the bond back early. This option benefits the issuer but it is at the expense of the bond investor, who will expect some form of compensation in the form of a slightly higher rate of interest.

The coupon payments represent a form of interest to the bond investor, who must be paid for tying up their money for the duration of the bond. The amount of the coupon is set by market forces – the balance of demand and supply in the general market for funds. In particular, the coupon needs to represent an effective rate of interest that is enough to justify the investor tying up their money, compared with other places they might invest that money instead. The interest rate will depend on the general level of rates (which is a macroeconomic question) and on the specific credit risk of the issuer.

Coupon, interest and return

A crucial thing about bonds is that the interest rate return to the investor comes from the relationship of the coupon payment the investor receives to the amount of funds the investor puts. Typically a bond is denominated in round numbers such as €100 or $1,000. Let’s take a $100 denomination bond. The issuer of such a bond expects to receive $100 by selling it to bond investors (ignoring fees and transaction costs). If the coupon is $5 a year then the crude interest rate is 5/100 or 5%. (This is a crude interest rate because it ignores the time value of money).

If an investor buys a bond which has already been issued and is trading in the market, then the price will probably no longer be $100. The price will reflect the prevailing market interest rate. Let’s assume the bond we just considered was issued at a time when the market interest rate for that type of bond was 5% so investors would willingly pay $100 for a bond promising annual coupon payments of $5. But now let’s assume that a year later market interest rates have fallen and the appropriate interest rate is now 4%. A new bond being issued now would only need to pay $4 to provide that crude 4% interest rate return to investors. A stream of coupon payments of $5 is obviously worth more than that.

So what happens to the one year old bond trading in the market? Its market price will rise until the ratio of the coupon to the bond price is 4%. That price will be $125, because 5/125 is 4%. Notice that the market interest has fallen but the bond’s market price has risen. This is the general rule: the price of bonds moves inversely to the market interest rate.

Other features of bonds: variable coupons, covenants, options, perpetual maturity, secured, asset-backed, seniority and inflation-linked

The bond described above was basic. It just had a fixed coupon payment for a number of years and then the principal was repaid. Many bonds are indeed like this. But it’s possible to modify the bond in various ways to suit the needs of bond issuers and investors.

For example the coupon can be made variable instead of fixed. It could be linked to short term market interest rates such as LIBOR. The bond would now be a floating rate security. Such securities are reasonably common, though mainly at shorter term maturities. For such a bond to be marketable it must appeal to investors and there are indeed some investors who would like to invest in a debt security which pays a return that is linked to market interest rates.

Another possibility is to constrain the freedom of the issuer by adding contractual restrictions known as covenants. A covenant is an additional aspect of the contract. An example might be to require the issuer to maintain a minimum level of interest cover (the ratio of operating profit to interest payments). This would reassure the bond investors that the company would have a contractual commitment to stay creditworthy. If the issuing company broke the covenant then the bond investors would have a legal right to take action, including possibly siezing assets of the company to ensure that the bonds could be repaid.

Bonds can be designed to pay a coupon whose value is linked to specific asset prices such as the price of gold or oil. This is a niche market but there are investors who find this useful and so they will pay for value of such a bond.

A bond can be issued with options. We mentioned above that a company might issue a bond, especially a very long maturity bond, which has an option for the company to repurchase the bond at the company’s decision (a call option). This protects the company from the risk of being locked into high interest rate funding when market rates have fallen. A more common form of option is the option to convert a bond into equity. This is known straightforwardly as a convertible bond. It might be suitable for an early stage company which wants to limit its interest payments to conserve cash. One way of doing this is to issue a bond with the option to convert to equity. Since that option has value, investors buying the bond will readily accept a lower coupon payment than in the absence of the option. If the early stage company is successful and its equity rises in value then the value of the option will be high and the investors will convert their bonds to equity. This has the effect of automatically increasing the company’s equity as it grows, which suits both the company and its shareholders. If on the other hand the company struggles, then the bond will not be worth converting and will remain as low coupon debt.

Bonds are usually issued for a fixed maturity. But it’s possible (though rare) for a bond to be perpetual. The British government has some bonds outstanding which are perpetual, meaning that there is no maturity date when the principal is returned. The bonds will keep paying the coupons indefinitely, so long as the British government is able to do so. Investors can get their funds back only by selling the bond to another investor.

Bonds may secured, meaning that there is a specific asset owned by the borrower which is pledged as collateral to the bond investor. If the bond issuer is unable to pay the coupon or repay the principal then the bond investor can seize the security. This is most likely to be either real estate or some well-defined physical asset. Most corporate bonds are unsecured and virtually all sovereign bonds are.

A particular type of secured bond is an asset-backed bond. This refers to a bond that is backed by a pool of cashflows such as mortgage payments, student loan payments, equipment leases and credit card receivables. A company (known as a special purpose vehicle – SPV) is set up to buy a portfolio of such assets, intending to achieve some diversification benefits. The SPV then issues bonds, which should be somewhat less risky than unsecured bonds because there is a well defined set of cashflows out of which the bond coupon and principal will be paid. But the process depends on both the quality of the underlying cashflows (low quality mortgages have a high default rate) and on the care with which the SPV is structured.

As one company can issue more than one bond, the question can arise, how do different bonds compare in the event of the issuer not being able to pay its obligations? Some bonds may be designated at issue as senior to others, which are known therefore as junior. The question of seniority is important in the event of default. A more senior bond is more likely to be repaid and so has lower credit risk. So a more risky, junior bond would pay a higher rate of interest, to reflect the higher credit risk.

Lastly, a bond can have coupons which are inflation-linked. A normal bond coupon is just paid in the money of the day, meaning that the real value of the coupon (and of the principal) is eroded by any price inflation. There is a market for inflation-linked bonds, mainly issued by governments but sometimes by companies. While inflation is currently very low in the world, there is no guarantee that it will always be so. Some investors, who wish to protect their wealth from inflation, want to buy inflation-linked bonds and many of the richer economies issue such bonds.

Conclusion: bond flexibility

The variety of bond types reflects the flexibility of this product. Any mutually agreed contract can be written into a bond. The majority of bonds, especially sovereign bonds, are relatively simple but there is ample scope for unusual or bespoke arrangements if it suits both issuer and investors.

Further reading

Davie Bowie innovated in finance too

 

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