Bond (finance)

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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) and/or to repay the principal at a later date, termed maturity. It is a formal contract to repay borrowed money with interest at fixed intervals.[ ! "hus a bond is li#e a loan$ the issuer is the borrower, the bond holder is the lender, and the coupon is the interest. %onds provide the borrower with external funds to finance long&term investments, or, in the case of government bonds, to finance current expenditure. 'ertificates of deposit ('(s) or commercial paper are considered to be money mar#et instruments and not bonds. %onds and stoc#s are both securities, but the ma)or difference between the two is that stoc#& holders are the owners of the company (i.e., they have an e*uity sta#e), whereas bond holders are lenders to the issuers. +nother difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stoc#s may be outstanding indefinitely. +n exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Contents
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1 Issuing bonds 2 Features of bonds 3 Types of bonds

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3.1 Bonds issued in foreign currencies

4 Trading and valuing bonds Investing in bonds

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.1 Bond indices

! "ee also # $eferences % &'ternal lin(s

[edit] Issuing bonds

%onds are issued by public authorities, credit institutions, companies and supranational institutions in the primary mar#ets. "he most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or ban#s, forming a syndicate, buy

an entire issue of bonds from an issuer and re&sell them to investors. "he security firm ta#es the ris# of being unable to sell on the issue to end investors. ,owever government bonds are instead typically auctioned.

[edit] Features of bonds

"he most important features of a bond are$

no)inal* principal or face a)ount + the a)ount on ,hich the issuer pays interest* and ,hich has to be repaid at the end. issue price + the price at ,hich investors buy the bonds ,hen they are first issued* ,hich ,ill typically be appro'i)ately e-ual to the no)inal a)ount. The net proceeds that the issuer receives are thus the issue price* less issuance fees. )aturity date + the date on ,hich the issuer has to repay the no)inal a)ount. .s long as all pay)ents have been )ade* the issuer has no )ore obligations to the bond holders after the )aturity date. The length of ti)e until the )aturity date is often referred to as the ter) or tenor or )aturity of a bond. The )aturity can be any length of ti)e* although debt securities ,ith a ter) of less than one year are generally designated )oney )ar(et instru)ents rather than bonds. /ost bonds have a ter) of up to thirty years. "o)e bonds have been issued ,ith )aturities of up to one hundred years* and so)e even do not )ature at all. In early 200 * a )ar(et developed in euros for bonds ,ith a )aturity of fifty years. In the )ar(et for 1.". Treasury securities* there are three groups of bond )aturities2
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short ter) 3bills42 )aturities up to one year5 )ediu) ter) 3notes42 )aturities bet,een one and ten years5 long ter) 3bonds42 )aturities greater than ten years.

coupon + the interest rate that the issuer pays to the bond holders. 1sually this rate is fi'ed throughout the life of the bond. It can also vary ,ith a )oney )ar(et inde'* such as 6IB7$* or it can be even )ore e'otic. The na)e coupon originates fro) the fact that in the past* physical bonds ,ere issued ,hich had coupons attached to the). 7n coupon dates the bond holder ,ould give the coupon to a ban( in e'change for the interest pay)ent.

Bond issued by the 8utch &ast India 9o)pany in 1!23

The -uality of the issue* ,hich influences the probability that the bondholders ,ill receive the a)ounts pro)ised* at the due dates. This ,ill depend on a ,hole range of factors. o Indentures and 9ovenants + .n indenture is a for)al debt agree)ent that establishes the ter)s of a bond issue* ,hile covenants are the clauses of such an agree)ent. 9ovenants specify the rights of bondholders and the duties of issuers* such as actions that the issuer is obligated to perfor) or is prohibited fro) perfor)ing. In the 1.".* federal and state securities and co))ercial la,s apply to the enforce)ent of these agree)ents* ,hich are construed by courts as contracts bet,een issuers and bondholders. The ter)s )ay be changed only ,ith great difficulty ,hile the bonds are outstanding* ,ith a)end)ents to the governing docu)ent generally re-uiring approval by a )a:ority 3or super;)a:ority4 vote of the bondholders.
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<igh yield bonds are bonds that are rated belo, invest)ent grade by the credit rating agencies. .s these bonds are )ore ris(y than invest)ent grade bonds* investors e'pect to earn a higher yield. These bonds are also called :un( bonds.

coupon dates + the dates on ,hich the issuer pays the coupon to the bond holders. In the 1.". and also in the 1.=. and &urope* )ost bonds are se)i; annual* ,hich )eans that they pay a coupon every si' )onths. 7ptionality2 7ccasionally a bond )ay contain an e)bedded option5 that is* it grants option;li(e features to the holder or the issuer2
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9allability + "o)e bonds give the issuer the right to repay the bond before the )aturity date on the call dates5 see call option. These bonds are referred to as callable bonds. /ost callable bonds allo, the issuer to repay the bond at par. >ith so)e bonds* the issuer has to pay a pre)iu)* the so called call pre)iu). This is )ainly the case for high;yield bonds. These have very strict covenants* restricting the issuer in its operations. To be free fro) these covenants* the issuer can repay the bonds early* but only at a high cost. ?utability + "o)e bonds give the holder the right to force the issuer to repay the bond before the )aturity date on the put dates5 see put option. 3@ote2 A?utableA denotes an e)bedded put option5 A?uttableA denotes that it )ay be putted.4 call dates and put dates+the dates on ,hich callable and putable bonds can be redee)ed early. There are four )ain categories.

. Ber)udan callable has several call dates* usually coinciding ,ith coupon dates. . &uropean callable has only one call date. This is a special case of a Ber)udan callable. .n .)erican callable can be called at any ti)e until the )aturity date.

. death put is an optional rede)ption feature on a debt instru)ent allo,ing the beneficiary of the estate of the deceased to put 3sell4 the bond 3bac( to the issuer4 in the event of the beneficiaryBs death or legal incapacitation. .lso (no,n as a AsurvivorBs optionA.

sin(ing fund provision of the corporate bond indenture re-uires a certain portion of the issue to be retired periodically. The entire bond issue can be li-uidated by the )aturity date. If that is not the case* then the re)ainder is called balloon )aturity. Issuers )ay either pay to trustees* ,hich in turn call rando)ly selected bonds in the issue* or* alternatively* purchase bonds in open )ar(et* then return the) to trustees. convertible bond lets a bondholder e'change a bond to a nu)ber of shares of the issuerBs co))on stoc(. e'changeable bond allo,s for e'change to shares of a corporation other than the issuer.

[edit] Types of bonds

Bond certificate for the state of "outh 9arolina issued in 1%#3 under the stateBs 9onsolidation .ct.

Fi'ed rate bonds have a coupon that re)ains constant throughout the life of the bond. Floating rate notes 3F$@s4 have a coupon that is lin(ed to an inde'. 9o))on indices include2 )oney )ar(et indices* such as 6IB7$ or &uribor* and 9?I 3the 9onsu)er ?rice Inde'4. 9oupon e'a)ples2 three )onth 1"8 6IB7$ C 0.20D* or t,elve )onth 9?I C 1. 0D. F$@ coupons reset periodically* typically every one or three )onths. In theory* any Inde' could be used as the basis for the coupon of an F$@* so long as the issuer and the buyer can agree to ter)s. Eero coupon bonds donBt pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal a)ount on the rede)ption date. .n e'a)ple of Fero coupon bonds are "eries & savings bonds issued by the 1.". govern)ent. Eero coupon bonds )ay be created fro) fi'ed rate bonds by a financial institutions separating Astripping offA the coupons fro) the principal. In other ,ords* the separated coupons and the final principal pay)ent of the bond are allo,ed to trade independently. "ee I7 3Interest 7nly4 and ?7 3?rincipal 7nly4.

NB : This is the 9ase for T; and &uro;Bills

Inflation lin(ed bonds* in ,hich the principal a)ount and the interest pay)ents are inde'ed to inflation. The interest rate is nor)ally lo,er than for fi'ed rate bonds ,ith a co)parable )aturity 3this position briefly reversed itself for short;ter) 1= bonds in 8ece)ber 200%4. <o,ever* as the principal a)ount gro,s* the pay)ents increase ,ith inflation. The govern)ent of the 1nited =ingdo) ,as the first to issue inflation lin(ed Gilts in the 1H%0s. Treasury Inflation;?rotected "ecurities 3TI?"4 and I; bonds are e'a)ples of inflation lin(ed bonds issued by the 1.". govern)ent. 7ther inde'ed bonds* for e'a)ple e-uity;lin(ed notes and bonds inde'ed on a business indicator 3inco)e* added value4 or on a countryBs G8?. .sset;bac(ed securities are bonds ,hose interest and principal pay)ents are bac(ed by underlying cash flo,s fro) other assets. &'a)ples of asset; bac(ed securities are )ortgage;bac(ed securities 3/B"Bs4* collateraliFed )ortgage obligations 39/7s4 and collateraliFed debt obligations 3987s4. "ubordinated bonds are those that have a lo,er priority than other bonds of the issuer in case of li-uidation. In case of ban(ruptcy* there is a hierarchy of creditors. First the li-uidator is paid* then govern)ent ta'es* etc. The first bond holders in line to be paid are those holding ,hat is called senior bonds. .fter they have been paid* the subordinated bond holders are paid. .s a result* the ris( is higher. Therefore* subordinated bonds usually have a lo,er credit rating than senior bonds. The )ain e'a)ples of subordinated bonds can be found in bonds issued by ban(s* and asset;bac(ed securities. The latter are often issued in tranches. The senior tranches get paid bac( first* the subordinated tranches later. ?erpetual bonds are also often called perpetuities. They have no )aturity date. The )ost fa)ous of these are the 1= 9onsols* ,hich are also (no,n as Treasury .nnuities or 1ndated Treasuries. "o)e of these ,ere issued bac( in 1%%% and still trade today* although the a)ounts are no, insignificant. "o)e ultra long;ter) bonds 3so)eti)es a bond can last centuries2 >est "hore $ailroad issued a bond ,hich )atures in 23!1 3i.e. 24th century44 are virtually perpetuities fro) a financial point of vie,* ,ith the current value of principal near Fero. Bearer bond is an official certificate issued ,ithout a na)ed holder. In other ,ords* the person ,ho has the paper certificate can clai) the value of the bond. 7ften they are registered by a nu)ber to prevent counterfeiting* but )ay be traded li(e cash. Bearer bonds are very ris(y because they can be lost or stolen. &specially after federal inco)e ta' began in the 1nited "tates* bearer bonds ,ere seen as an opportunity to conceal inco)e or assets.[2] 1.". corporations stopped issuing bearer bonds in the 1H!0s* the 1.". Treasury stopped in 1H%2* and state and local ta'; e'e)pt bearer bonds ,ere prohibited in 1H%3. [3] $egistered bond is a bond ,hose o,nership 3and any subse-uent purchaser4 is recorded by the issuer* or by a transfer agent. It is the

alternative to a Bearer bond. Interest pay)ents* and the principal upon )aturity* are sent to the registered o,ner.

/unicipal bond is a bond issued by a state* 1.". Territory* city* local govern)ent* or their agencies. Interest inco)e received by holders of )unicipal bonds is often e'e)pt fro) the federal inco)e ta' and fro) the inco)e ta' of the state in ,hich they are issued* although )unicipal bonds issued for certain purposes )ay not be ta' e'e)pt. Boo(;entry bond is a bond that does not have a paper certificate. .s physically processing paper bonds and interest coupons beca)e )ore e'pensive* issuers 3and ban(s that used to collect coupon interest for depositors4 have tried to discourage their use. "o)e boo(;entry bond issues do not offer the option of a paper certificate* even to investors ,ho prefer the).[4] 6ottery bond is a bond issued by a state* usually a &uropean state. Interest is paid li(e a traditional fi'ed rate bond* but the issuer ,ill redee) rando)ly selected individual bonds ,ithin the issue according to a schedule. "o)e of these rede)ptions ,ill be for a higher value than the face value of the bond. >ar bond is a bond issued by a country to fund a ,ar. "erial bond is a bond that )atures in install)ents over a period of ti)e. In effect* a I100*000* ;year serial bond ,ould )ature in a I20*000 annuity over a ;year interval. $evenue bond is a special type of )unicipal bond distinguished by its guarantee of repay)ent solely fro) revenues generated by a specified revenue;generating entity associated ,ith the purpose of the bonds. $evenue bonds are typically Anon;recourse*A )eaning that in the event of default* the bond holder has no recourse to other govern)ental assets or revenues.

[edit] Bonds issued in foreign currencies

-ome companies, ban#s, 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 mar#ets. "he proceeds from the issuance of these bonds can be used by companies to brea# into foreign mar#ets, or can be converted into the issuing company.s local currency to be used on existing operations. /oreign issuer bonds can also be used to hedge foreign exchange rate ris#. -ome of these bonds are called by their nic#names, such as the 0samurai bond.0

&urodollar bond* a 1.". dollar;deno)inated bond issued by a non;1.". entity outside the 1."[ ] =angaroo bond* an .ustralian dollar;deno)inated bond issued by a non; .ustralian entity in the .ustralian )ar(et

/aple bond* a 9anadian 8ollar;deno)inated bond issued by a non; 9anadian entity in the 9anadian )ar(et "a)urai bond* a Japanese Ken;deno)inated bond issued by a non; Japanese entity in the Japanese )ar(et "hibosai Bond is a private place)ent bond in Japanese )ar(et ,ith distribution li)ited to institutions and ban(s. Kan(ee bond* a 1" 8ollar;deno)inated bond issued by a non;1" entity in the 1" )ar(et "hogun bond* a non;yen;deno)inated bond issued in Japan by a non; Japanese institution or govern)ent[!] Bulldog bond* a pound sterling;deno)inated bond issued in 6ondon by a foreign institution or govern)ent /atriosh(a Bond* a $ussian rouble;deno)inated bond issued in the $ussian Federation by non;$ussian entities. The na)e derives fro) the fa)ous $ussian ,ooden dolls* /atriosh(a* popular a)ong foreign visitors to $ussia .rirang bond* a =orean ,on;deno)inated bond issued by a non;=orean entity in the =orean )ar(et[#] =i)chi bond* a non;=orean ,on;deno)inated bond issued by a non;=orean entity in the =orean )ar(et.[%] For)osa bond* a non;@e, Tai,an 8ollar;deno)inated bond issued by a non;Tai,an entity in the Tai,an )ar(et [H] ?anda bond* a 9hinese ren)inbi;deno)inated bond issued by a non;9hina entity in the ?eopleBs $epublic of 9hina )ar(et [10] "tate of Israel bond* a bond deno)inated in )ultiple currencies issued by the "tate of Israel through the 8evelop)ent 9orporation of Israel.

[edit] Trading and valuing bonds

"ee also2 Bond valuation

"he interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current mar#et interest rates, the length of the term and the creditworthiness of the issuer. "hese factors are li#ely to change over time, so the mar#et price of a bond will vary after it is issued. "his price is expressed as a percentage of nominal value. %onds are not necessarily issued at par ( 112 of face value, corresponding to a price of 11), but bond prices converge to par when they approach maturity (if the mar#et 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. +t other times, prices can be above par (bond is priced at greater than 11), which is called trading at a premium, or below par (bond is priced at less than 11), which is called trading at a discount. 3ost government bonds are denominated in units of 4 111, if in the 5nited -tates, or in units of 6 11, if in the 5nited 7ingdom. ,ence, a deep discount 5- bond, selling at a price of 89.:;, indicates a selling price of 489:.;1 per bond sold. (<ften, in the 5-, bond prices are

*uoted in points and thirty&seconds of a point, rather than in decimal form.) -ome short&term bonds, such as the 5.-. "reasury %ill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. "his is called a discount bond. "he mar#et 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. "hat relationship defines the redemption yield on the bond, which represents the current mar#et interest rate for bonds with similar characteristics. "he yield and price of a bond are inversely related so that when mar#et interest rates rise, bond prices fall and vice versa. "hus 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. "he mar#et price of a bond may include the accrued interest since the last coupon date. (-ome bond mar#ets 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 "ccrual bond!) The price e#cluding accrued interest is known as the flat or clean price ! "he interest rate ad)usted 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). The relationship between yield and maturity for otherwise identical bonds is called a yield cur$e. %onds mar#ets, unli#e stoc# or share mar#ets, often do not have a centralized exchange or trading system. =ather, in most developed bond mar#ets such as the 5.-., >apan and ?estern @urope, bonds trade in decentralized, dealer&based over&the&counter mar#ets. In such a mar#et, mar#et li*uidity is provided by dealers and other mar#et participants committing ris# capital to trading activity. In the bond mar#et, when an investor buys or sells a bond, the counterparty to the trade is almost always a ban# or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond 0in inventory.0 "he dealer.s position is then sub)ect to ris#s of price fluctuation. In other cases, the dealer immediately resells the bond to another investor. %ond mar#ets can also differ from stoc# mar#ets in that, in some mar#ets, investors sometimes do not pay bro#erage commissions to dealers with whom they buy or sell bonds. =ather, 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 0bid0 price && and the price at which he or she sells the same bond to another investor&&the 0as#0 or 0offer0 price. "he bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

[edit] Investing in bonds

%onds are bought and traded mostly by institutions li#e pension funds, insurance companies and ban#s. 3ost individuals who want to own bonds do so through bond funds. -till, in the 5.-., nearly 12 of all bonds outstanding are held directly by households.

-ometimes, bond mar#ets rise (while yields fall) when stoc# mar#ets fall. 3ore relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of shares. "hus bonds are generally viewed as safer investments than stoc#s, but this perception is only partially correct. %onds do suffer from less day&to&day volatility than stoc#s, and bonds. interest payments are often higher than the general level of dividend payments. %onds are li*uid A it is fairly easy to sell one.s bond investments, though not nearly as easy as it is to sell stoc#s A and the comparative certainty of a fixed interest payment twice per year is attractive. %ondholders also en)oy a measure of legal protection$ under the law of most countries, if a company goes ban#rupt, its bondholders will often receive some money bac# (the recovery amount), whereas the company.s stoc# often ends up valueless. ,owever, bonds can also be ris#y$

Fi'ed rate bonds are sub:ect to interest rate risk* )eaning that their )ar(et prices ,ill decrease in value ,hen the generally prevailing interest rates rise. "ince the pay)ents are fi'ed* a decrease in the )ar(et price of the bond )eans an increase in its yield. >hen the )ar(et interest rate rises* the )ar(et price of bonds ,ill fall* reflecting investorsB ability to get a higher interest rate on their )oney else,here + perhaps by purchasing a ne,ly issued bond that already features the ne,ly higher interest rate. @ote that this drop in the bondBs )ar(et price does not affect the interest pay)ents to the bondholder at all* so long;ter) investors ,ho ,ant a specific a)ount at the )aturity date need not ,orry about price s,ings in their bonds and do not suffer fro) interest rate ris(.

Brice changes in a bond will also immediately affect mutual funds 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. "his can be damaging for professional investors such as ban#s, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately 0mar#ed to mar#et0 or not). If there is any chance a holder of individual bonds may need to sell his bonds and 0cash out0, interest rate ris# could become a real problem. ('onversely, bonds. mar#et prices would increase if the prevailing interest rate were to drop, as it did from :11 through :11C.) <ne way to *uantify the interest rate ris# on a bond is in terms of its duration. @fforts to control this ris# are called immunization or hedging.

Bond prices can beco)e volatile depending on the credit rating of the issuer ; for instance if the credit rating agencies li(e "tandard L ?oorBs and /oodyBs upgrade or do,ngrade the credit rating of the issuer. . do,ngrade ,ill cause the )ar(et price of the bond to fall. .s ,ith interest rate ris(* this ris( does not affect the bondBs interest pay)ents 3provided the issuer does not actually default4* but puts at ris( the )ar(et price* ,hich affects )utual funds holding these bonds* and holders of individual bonds ,ho )ay have to sell the). . co)panyBs bondholders )ay lose )uch or all their )oney if the co)pany goes ban(rupt. 1nder the la,s of )any countries 3including the 1nited "tates and 9anada4* bondholders are in line to receive the proceeds of the sale of the assets of a li-uidated co)pany ahead of so)e other creditors. Ban( lenders* deposit holders 3in the case of a deposit ta(ing institution such as a ban(4 and trade creditors )ay ta(e precedence.

"here is no guarantee of how much money will remain to repay bondholders. +s an example, after an accounting scandal and a 'hapter ban#ruptcy at the giant telecommunications

company ?orldcom, in :11D its bondholders ended up being paid C9.8 cents on the dollar. In a ban#ruptcy involving reorganization or recapitalization, as opposed to li*uidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

"o)e bonds are callable* )eaning that even though the co)pany has agreed to )a(e pay)ents plus interest to,ards the debt for a certain period of ti)e* the co)pany can choose to pay off the bond early. This creates reinvest)ent ris(* )eaning the investor is forced to find a ne, place for his )oney* and the investor )ight not be able to find as good a deal* especially because this usually happens ,hen interest rates are falling.

[edit] Bond indices

"ee also2 Bond )ar(et inde'

+ number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the -EB 911 or =ussell Indexes for stoc#s. "he most common +merican benchmar#s are the (ex) Fehman +ggregate, 'itigroup %IG and 3errill Fynch (omestic 3aster. 3ost 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.

[edit] See also

Bond )ar(et Bond fund Bond )ar(et inde' Brady Bonds &urobond Bond credit rating 9ollective action clause 9riticis) of debt 8ebenture 8eferred financing costs Fi'ed inco)e I))uniFation 3finance4 6ist of accounting topics 6ist of econo)ics topics 6ist of finance topics