A bond is a kind of security sold by countries and corporations to get money from investors.
People buy the bonds and thus lend their money to the company or the government, expecting to get a certain income. As a rule, the full amount, term, and amount of this revenue payment (if multiple payments are planned) are known at the purchase. The ability to estimate your benefit in advance is the main difference between a bond and other securities.
Bonds are repaid at maturity date, which means the issuer pays the nominal value to the bondholders. There are also perpetual bonds, for which the issuer commits to pay regular income on them, but may never be repaid. However, the issuer usually has the right to repurchase them for nominal value at certain dates, for example, every five or ten years.
Investment and structured bonds are considered complicated instruments because the income on them is almost unpredictable. And in some cases, when they are repaid, the owners receive even less than the nominal value. The main risk for the investors is the bankruptcy of the issuing company. In this case, they can lose all the invested money. Unlike deposits, they are not protected by the deposit insurance system.
How do Bonds work
Bonds are actually debenture loans. They are issued by a company that needs money, or by the government, which can also be an issuer. From the seller's hand, bond selling is a kind of borrowing money. From the buyer's hand, bond buying is a form of investment, because it gives the right of a guaranteed principal return and an interest payment flow. Some types of bonds also have other benefits, such as the convertibility, allowing to change the bond into shares of the issuing company.
The bond market typically moves in reverse depending on interest rates. Bond prices decrease when interest rates are going up and increase when interest rates are going down.
Types of Bonds
Types of bonds differ in several ways, but usually they differ by issuer.
Government bonds are issued by countries or individual regions to cover budget deficits.
Municipal bonds are issued by local governments, usually to finance various projects.
Corporate bonds are issued by companies to get money for their development.
Investment and structure bonds are issued by banks, brokers and management companies to put investors' money into other securities and receive a commission for it.
Commercial bonds are issued by private companies, which can also float a special kind of bond. These bonds are distributed by address and closed subscription. But you can't just go to the stock exchange and buy them.
Varieties of Bonds
There are many varieties of bonds available for investments. They are classified by the rate, type of interest or coupon payments, by the fact that they are withdrawn by the issuer, or by other characteristics.
Zero-coupon bonds. No interest is paid on zero-coupon bonds, nominal value is given at a discount price instead. The nominal value will bring income at maturity, when the bondholder receives the full nominal value of the bond. Treasury bills in the U.S. are no-coupon bonds.
Convertible bonds are debt instruments with an option, allowing bondholders to convert the loan into shares (equity) in certain conditions and moments (e.g., a share price increase). As an example: a company wants to borrow $1 million to develop a new project. It can borrow money by issuing bonds with a coupon of 12% and a maturity in 10 years, but knowing about investors wanting to buy bonds with an 8% coupon that allows the bond to be converted into shares (in case of stock price rising above a certain value), they would prefer to issue convertible bonds.
Callable bonds also have an option, but it is different. Issuing company can "call back" this bond before it matures.
A callable bond is more dangerous for the bond buyer because the possibility of the bond being called back increases when the bond price rises. When interest rates decrease, bond prices go up. Therefore, a callable bond is not as valuable as a non-callable bond with the same maturity, credit rating and coupon rate.
Puttable bonds allow bondholders to sell a company's bond before it matures. This is important for investors that are concerned that the bond value may fall, or think of interest rate development and want to get their principal back before the bond value falls.
An issuer can give a put option in a bond, which benefits bondholders in exchange for a coupon with lower rate or to encourage bond holders for initial loan. A bond without a put option usually has a lower price than a puttable bond, but both of them have the same main characteristics (credit rating, maturity and coupon rate). Puttable bond represents more value to bondholders.
An issuer can combine integrated puts, calls and convertibility infinitely. There are no strict rules for each of these options, and some bonds contain more than one type of "option", which can make comparison difficult. Typically, individual investors ask bond professionals to select bonds or bond funds matching their investment objectives.
There is a No-Name-Corporation. It wants to borrow $1 million for building a new factory, but it can’t get money from a bank. So, No-Name-Company decides to get financing by selling $1 million in bonds to investors. It promises to pay bondholders 5% annually for 5 years, paying interest six-monthly. Each bond has a nominal value of $1,000. No-Name-Company is selling a total of 1,000 bonds.