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Bond (finance)
Encyclopedia
In finance
, a bond is a debt security
, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest
(the coupon
) to use and/or to repay the principal at a later date, termed maturity
. A bond is a formal contract
to repay borrowed money with interest at fixed intervals (ex semi annual, annual, sometimes monthly).
Thus a bond is like a loan
: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investment
s, or, in the case of government bonds
, to finance current expenditure. Certificates of deposit
(CDs) or commercial paper
are considered to be money market
instruments and not bonds.
Bonds and stock
s are both securities
, but the major difference between the two is that (capital) stockholders have an equity
stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond
, which is a perpetuity
(i.e., bond with no maturity).
s. The most common process of issuing bonds is through underwriting
. In underwriting, one or more securities firms or banks, forming a syndicate
, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunner
s who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so.
In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market.
Sometimes the documentation allows the issuer to borrow more at a later date by issuing further bonds on the same terms as before, but at the current market price. This is called a tap issue or bond tap.
Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law. Not all of the following bonds are restricted for purchase by investors in the market of issuance.
These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000 in the United States
, or in units of £100 in the United Kingdom
. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.
The market price of a bond is the present value
of all expected future interest
and principal payments of the bond discounted at the bond's redemption yield
, or rate of return
. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield (see below) and the expected capital gain
or loss: roughly the current yield
plus the capital gain (negative for loss) per year until redemption.
The market price
of a bond may include the accrued interest
since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "full" or "dirty price
". (See also Accrual bond
.) The price excluding accrued interest is known as the "flat" or "clean price
".
The interest rate adjusted for (divided by) the current price of the bond is called the current yield
(this is the nominal yield
multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve
. A yield curve is essentially a measure of the term structure of bonds.
Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond market
s such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter
markets. In such a market, market liquidity
is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty
to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.
Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor—the "bid" price—and the price at which he or she sells the same bond to another investor—the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.
s. Most individuals who want to own bonds do so through bond fund
s. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households.
Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are generally viewed as safer investments than stock
s, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level of dividend
payments. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt
, its bondholders will often receive some money back (the recovery amount
), whereas the company's stock often ends up valueless. However, bonds can also be risky but less risky than stocks:
Bonds are also subject to various other risks such as call and prepayment risk, credit risk
, reinvestment risk
, liquidity risk
, event risk, exchange rate risk, volatility risk
, inflation risk, sovereign risk and yield curve risk.
Price changes in a bond will also immediately affect mutual fund
s that hold these bonds. If the value of the bonds held in a trading portfolio
has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not).
If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk
could become a real problem (conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003). One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization
or hedging
.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom
, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
or Russell Indexes
for stocks
. The most common American benchmarks are the Barclays Capital Aggregate (ex Lehman Aggregate), Citigroup BIG and Merrill Lynch Domestic Master
. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.
Market specific:
General:
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a bond is a debt security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
(the coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
) to use and/or to repay the principal at a later date, termed maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
. A bond is a formal contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
to repay borrowed money with interest at fixed intervals (ex semi annual, annual, sometimes monthly).
Thus a bond is like a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s, or, in the case of government bonds
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
, to finance current expenditure. Certificates of deposit
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
(CDs) or commercial paper
Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
are considered to be money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
instruments and not bonds.
Bonds and stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s are both securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, but the major difference between the two is that (capital) stockholders have an equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond
Consols
Consol is a form of British government bond , dating originally from the 18th century. The first consols were originally issued in 1751...
, which is a perpetuity
Perpetuity
A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence...
(i.e., bond with no maturity).
Issuance
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary marketPrimary market
The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process...
s. The most common process of issuing bonds is through underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
. In underwriting, one or more securities firms or banks, forming a syndicate
Syndicate
A syndicate is a self-organizing group of individuals, companies or entities formed to transact some specific business, or to promote a common interest or in the case of criminals, to engage in organized crime...
, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunner
Bookrunner
In investment banking, a bookrunner is usually the main underwriter or lead-manager/arranger/coordinator in equity, debt, or hybrid securities issuances. The bookrunner usually syndicates with other investment banks in order to lower its risk. The bookrunner is listed first among all underwriters...
s who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so.
In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market.
Sometimes the documentation allows the issuer to borrow more at a later date by issuing further bonds on the same terms as before, but at the current market price. This is called a tap issue or bond tap.
Features
The most important features of a bond are,- nominal, principal or face amount — the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.
- issue price — the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.
- maturityMaturity (finance)In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
date — the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities:- short term (bills): maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments)
- medium term (notes): maturities between six to twelve years;
- long term (bonds): maturities greater than twelve years.
- couponCoupon (bond)A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
— the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
- The "quality" of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors.
- Indentures and Covenants — An indentureIndentureAn indenture is a legal contract reflecting a debt or purchase obligation, specifically referring to two types of practices: in historical usage, an indentured servant status, and in modern usage, an instrument used for commercial debt or real estate transaction.-Historical usage:An indenture is a...
is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majorityMajorityA majority is a subset of a group consisting of more than half of its members. This can be compared to a plurality, which is a subset larger than any other subset; i.e. a plurality is not necessarily a majority as the largest subset may consist of less than half the group's population...
(or super-majoritySupermajorityA supermajority or a qualified majority is a requirement for a proposal to gain a specified level or type of support which exceeds a simple majority . In some jurisdictions, for example, parliamentary procedure requires that any action that may alter the rights of the minority has a supermajority...
) vote of the bondholders. - High yield bonds are bonds that are rated below investment grade by the credit rating agenciesCredit rating agencyA Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.
- Indentures and Covenants — An indenture
- coupon dates — the dates on which the issuer pays the coupon to the bond holders. In the U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.
- Optionality: Occasionally a bond may contain an embedded optionEmbedded optionAn Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options...
; that is, it grants option-likeOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
features to the holder or the issuer:- Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at parPar valuePar value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost. - Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
. These are referred to as retractable or putable bonds. - call dates and put dates—the datesOption styleIn finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American options. These options - as well as others where the...
on which callable and putable bonds can be redeemed early. There are four main categories.- A Bermudan callable has several call dates, usually coinciding with coupon dates.
- A European callable has only one call date. This is a special case of a Bermudan callable.
- An American callable can be called at any time until the maturity date.
- A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
- Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option
- sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
- convertible bondConvertible bondIn finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...
lets a bondholder exchange a bond to a number of shares of the issuer's common stock. - exchangeable bondExchangeable bondExchangeable bond is a type of hybrid security consisting of a straight bond and an embedded option to exchange the bond for the stock of a company other than the issuer at some future date and under prescribed conditions. An exchangeable bond is different from a convertible bond...
allows for exchange to shares of a corporation other than the issuer.
Types
The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.- Fixed rate bondFixed rate bondIn finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate...
s have a coupon that remains constant throughout the life of the bond. - Floating rate noteFloating rate noteFloating rate notes are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter...
s (FRNs) have a variable coupon that is linked to a reference rateReference rateA reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
of interest, such as LIBOR or EuriborEuriborThe Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market .-Scope:...
. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months. - Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par valuePar valuePar value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only). - Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United KingdomUnited KingdomThe United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
was the first sovereign issuer to issue inflation linked GiltsGiltsGilts are bonds issued by certain national governments. The term is of British origin, and originally referred to the debt securities issued by the Bank of England, which had a gilt edge. Hence, they are called gilt-edged securities, or gilts for short. The term is also sometimes used in Ireland...
in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
- Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
- Asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securitiesMortgage-backed securityA mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS's), collateralized mortgage obligationCollateralized mortgage obligationA collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
s (CMOs) and collateralized debt obligationCollateralized debt obligationCollateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s (CDOs). - Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidationLiquidationIn law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
. In case of bankruptcy, there is a hierarchy of creditors. First the liquidatorLiquidator (law)In law, a liquidator is the officer appointed when a company goes into winding-up or liquidation who has responsibility for collecting in all of the assets of the company and settling all claims against the company before putting the company into dissolution....
is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later. - Perpetual bondsPerpetual bondsPerpetual bond, which is also known as a Perpetual or just a Perp, is a bond with no maturity date. Therefore, it may be treated as equity, not as debt. Perpetual bonds pay coupons forever, and the issuer does not have to redeem them. Their cash flows are, therefore, those of a perpetuity.Examples...
are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero. - Bearer bondBearer bondA bearer bond is a debt security issued by a business entity, such as a corporation, or by a government. It differs from the more common types of investment securities in that it is unregistered – no records are kept of the owner, or the transactions involving ownership. Whoever physically...
is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983. - Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bondBearer bondA bearer bond is a debt security issued by a business entity, such as a corporation, or by a government. It differs from the more common types of investment securities in that it is unregistered – no records are kept of the owner, or the transactions involving ownership. Whoever physically...
. Interest payments, and the principal upon maturity, are sent to the registered owner. - Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the “full faith and credit” of the federal government. For that reason, this type of bond is often referred to as risk-free.
- Municipal bond
Municipal bondA municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exemptTax advantageTax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free...
from the federal income taxIncome taxAn income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt. - Build America Bonds (BABs) is a new form of municipal bondMunicipal bondA municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
authorized by the American Recovery and Reinvestment Act of 2009American Recovery and Reinvestment Act of 2009The American Recovery and Reinvestment Act of 2009, abbreviated ARRA and commonly referred to as the Stimulus or The Recovery Act, is an economic stimulus package enacted by the 111th United States Congress in February 2009 and signed into law on February 17, 2009, by President Barack Obama.To...
. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds. - Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.
- Lottery bondLottery BondLottery Bonds are a type of government bond in which some randomly selected bonds within the issue are redeemed at a higher value than the face value of the bond.They are government bonds and only issued by a government...
is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond. - War bondWar bondWar bonds are debt securities issued by a government for the purpose of financing military operations during times of war. War bonds generate capital for the government and make civilians feel involved in their national militaries...
is a bond issued by a country to fund a war. - Serial bondSerial bondSerial bonds are financial bonds that mature in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval. Bond issues consisting of a series of blocks of securities maturing in sequence, the coupon rate can be different....
is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval. - Revenue bondRevenue bondA revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds, rather than from a tax...
is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues. - Climate bondClimate bondClimate bonds are fixed-income financial instruments linked in some way to climate change solutions.Climate Bonds are issued in order to raise finance for climate change solutions - climate change mitigation or adaptation related projects or programs...
is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation or adaptation related projects or programs.
Foreign currencies
Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency.Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law. Not all of the following bonds are restricted for purchase by investors in the market of issuance.
- EurodollarEurodollarEurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term...
bond, a U.S. dollar-denominated bond issued by a non-U.S. entityUnited States entityUnited States entity is a designation given to some entities , e.g. for International Traffic in Arms Regulations purposes:For purposes of the preceding paragraph, a U.S. entity is a firm incorporated in the United States that is controlled by U.S. citizens or by another U.S...
outside the U.S - Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US market
- Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the Australian market
- Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian entity in the Canadian market
- Samurai bondSamurai bondA samurai bond is “a yen-dominated bond issued in Tokyo by non- Japanese companies and subject to Japanese regulations”. These bonds provide the issuer with an access to Japanese capital, which can be used for local investments or for financing operations outside Japan. Foreign borrowers may want...
, a Japanese yen-denominated bond issued by a non-Japanese entity in the Japanese market - Uridashi bondUridashi bondsAn Uridashi bond is a bond denominated in a foreign currency and sold directly to Japanese household investors. An Uridashi bond is normally issued in high-yielding currencies such as New Zealand Dollars or Australian Dollars in order to give the investor a higher return than the historically low...
, a non-yen-demoninated bond sold to Japanese retail investors. - Shibosai Bond is a private placement bond in Japanese market with distribution limited to institutions and banks.
- Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or government
- Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or government
- Matrioshka bond, a Russian rouble-denominated bond issued in the Russian Federation by non-Russian entities. The name derives from the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia
- Arirang bondArirang bondAn Arirang bond is a won-denominated bond issued by a foreign entity in South Korea. The name refers to Arirang, a Korean folk song. The market for Arirang bonds is extremely small, constituting less than 0.2% of corporate bond issuance in South Korea. The Asian Development Bank was the first to...
, a Korean won-denominated bond issued by a non-Korean entity in the Korean market - Kimchi bondKimchi bondA Kimchi bond is a non-won-denominated bond issued in the South Korean market. The name refers to kimchi, a Korean side dish. Woori Bank, which is credited with coining the term, defines it as solely referring to bonds from foreign issuers, a definition echoed by the Ministry of Finance and Economy...
, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean market - Formosa bondFormosa bondA Formosa bond is a non-New Taiwan Dollar-denominated bond issued in Taiwan by a foreign institution.-History:The major designer and promoter of the Formosa bond was Lee Shyan-yuan, a board member of Taiwan's market regulator, the Financial Supervisory Commission...
, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the Taiwan market - Panda bondPanda bondA Panda bond is a Chinese renminbi-denominated bond from a non-Chinese issuer, sold in the People's Republic of China. The first two Panda bonds were issued in October 2005 on the same day by the International Finance Corporation and the Asian Development Bank. Their terms were 1.13 billion yuan of...
, a Chinese renminbi-denominated bond issued by a non-China entity in the People's Republic of China market - Dimsum bond, a Chinese renminbi-denominated bond issued by a Chinese entity in Hong Kong. Enables foreign investors forbidden from investing in Chinese corporate debt in mainland China to invest in and be exposed to Chinese currency in Hong Kong.
- Huaso bond, a Chilean peso-denominated bond issued by a non-Chilean entity in the Chilean market.
Reckoning
The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the creditworthiness of the issuer.These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000 in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, or in units of £100 in the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.
The market price of a bond is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of all expected future interest
Future interest
In property law and real estate, a future interest is a legal right to property ownership that does not include the right to present possession or enjoyment of the property. Future interests are created on the formation of a defeasible estate; that is, an estate with a condition or event...
and principal payments of the bond discounted at the bond's redemption yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
, or rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield (see below) and the expected capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
or loss: roughly the current yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
plus the capital gain (negative for loss) per year until redemption.
The market price
Market price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
of a bond may include the accrued interest
Accrued interest
In finance, accrued Interest is the interest that has accumulated since the principal investment, or since the previous interest payment if there has been one already. For a financial instrument such as a bond, interest is calculated and paid in set intervals...
since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "full" or "dirty price
Dirty price
The dirty price of a bond represents the value of a bond, exclusive of any commissions or fees. The dirty price is also called the "full price" or the "all in price."-Bond Pricing:...
". (See also Accrual bond
Accrual bond
An accrual bond is a fixed-interest bond that is issued at its face value and repaid at the end of the maturity period together with the accrued interest. In Germany, the accrued interest is compounded. In contrast to zero-coupon bonds, accrual bonds have a clearly stated coupon rate....
.) The price excluding accrued interest is known as the "flat" or "clean price
Clean price
In finance, the clean price is the price of a bond excluding any interest that has accrued since issue or the most recent coupon payment. This is to be compared with the dirty price, which is the price of a bond including the accrued interest....
".
The interest rate adjusted for (divided by) the current price of the bond is called the current yield
Current yield
The current yield, interest yield, income yield, flat yield or running yield is a financial term used in reference to bonds and other fixed-interest securities such as gilts...
(this is the nominal yield
Nominal yield
Nominal yield or coupon yield is the coupon rate of a fixed income security, which is a fixed percentage of the par value. Unlike current yield, it does not vary with the market price of the security....
multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
. A yield curve is essentially a measure of the term structure of bonds.
Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond market
Bond market
The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...
s such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
markets. In such a market, market liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.
Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor—the "bid" price—and the price at which he or she sells the same bond to another investor—the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.
Investing in bonds
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies and bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s. Most individuals who want to own bonds do so through bond fund
Bond fund
A bond fund is a collective investment scheme that invests in bonds and other debt securities. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than...
s. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households.
Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are generally viewed as safer investments than stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level of dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
payments. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, its bondholders will often receive some money back (the recovery amount
Recovery amount
When a bond or other financial derivative defaults, the recovery amount is the amount that the underlying company can afford to pay. This is usually a result of a liquidation of the company's assets and generally results in a lower amount than the par value....
), whereas the company's stock often ends up valueless. However, bonds can also be risky but less risky than stocks:
- Fixed rate bonds are subject to interest rate riskInterest rate riskInterest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market priceMarket priceIn economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk.
Bonds are also subject to various other risks such as call and prepayment risk, credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
, reinvestment risk
Reinvestment risk
Reinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available...
, liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
, event risk, exchange rate risk, volatility risk
Volatility risk
Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlyings is a major influencer of prices....
, inflation risk, sovereign risk and yield curve risk.
Price changes in a bond will also immediately affect mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s that hold these bonds. If the value of the bonds held in a trading portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not).
If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
could become a real problem (conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003). One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization
Immunization (finance)
In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
or hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
.
- Bond prices can become volatile depending on the credit rating of the issuer – for instance if the credit rating agenciesCredit rating agencyA Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
like Standard & Poor'sStandard & Poor'sStandard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
and Moody'sMoody'sMoody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
upgrade or downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
- A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom
MCI Inc.
MCI, Inc. is an American telecommunications subsidiary of Verizon Communications that is headquartered in Ashburn, Virginia...
, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
- Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment riskReinvestment riskReinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available...
, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
Bond indices
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
or Russell Indexes
Russell Indexes
The Russell Indexes are a family of global equity indices that allow investors to track the performance of distinct market segments worldwide. Many investors use mutual funds or exchange-traded funds based on the Russell Indexes as a way of gaining exposure to certain portions of the U.S. stock...
for stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
. The most common American benchmarks are the Barclays Capital Aggregate (ex Lehman Aggregate), Citigroup BIG and Merrill Lynch Domestic Master
Merrill Lynch Domestic Master
The Merrill Lynch Domestic Master is a common American Bond index, analogous to the S&P 500 for stocks, owned by Merrill Lynch. The Domestic Master is similar to the Salomon BIG or the Lehman U.S. Aggregate . The Domestic Master Index was created on December 31, 1975...
. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.
See also
- Bond marketBond marketThe bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...
- Bond fundBond fundA bond fund is a collective investment scheme that invests in bonds and other debt securities. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than...
- Bond market indexBond market indexA bond market index is a composite listing of bonds or fixed income instruments and a statistic reflecting the composite value of its components...
- Bond credit ratingBond credit ratingIn investment, the bond credit rating assesses the credit worthiness of a corporation's or government debt issues. It is analogous to credit ratings for individuals.-Table:...
- Collective action clauseCollective action clauseA collective action clause allows a supermajority of bondholders to agree a debt restructuring that is legally binding on all holders of the bond, including those who vote against the restructuring. Bondholders generally opposed such clauses in the 1980s and 1990s, fearing that it gave debtors too...
- DebentureDebentureA debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note...
- Deferred financing costs
- GDP-linked bondGDP-linked bondIn finance, a GDP-linked bond is a debt security in which the authorized issuer promises to pay a return, in addition to amortization, that varies with the behavior of Gross Domestic Product . This type of security can be thought as a “stock on a country” in the sense that is has “equity-like”...
- Immunization (finance)Immunization (finance)In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
- Short rate modelShort rate modelIn the context of interest rate derivatives, a short-rate model is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written r_t \,.-The short rate:...
- Promissory notePromissory noteA promissory note is a negotiable instrument, wherein one party makes an unconditional promise in writing to pay a determinate sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms.Referred to as a note payable in accounting, or...
Market specific:
- Brady BondsBrady BondsBrady bonds are dollar-denominated bonds, issued mostly by Latin American countries in the 1980s, named after U.S. Treasury Secretary Nicholas Brady.-History:...
- Build America BondsBuild America BondsBuild America Bonds are taxable municipal bonds that carry special tax credits and federal subsidies for either the bond issuer or the bondholder. Build America Bonds were created under Section 1531 of Title I of Division B of the American Recovery and Reinvestment Act that U.S. President Barack...
- EurobondEurobondA Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for...
General:
- Criticism of debtCriticism of debtThis article is about criticism of, and arguments against debt.There are many arguments against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. Usually these refer to conditions under which debt should not be used as a solution, e.g. to fund...
- Fixed incomeFixed incomeFixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
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