Introduction to bonds
In this article, Rodolphe Chollat-Namy (ESSEC Business School, Master in Management, 2019-2023) introduces you to bonds.
While the bond market is growing fast and is worth about $115,000 billion as of 2021, in the following series of articles we will try to understand what it is all about. It is therefore appropriate here, firstly, to try to define what a bond is.
What is a bond?
A bond is a debt security, i.e. a tradable financial asset, that represents a loan made by an investor to a borrower. It allows the issuer to finance its investment projects and the creditor to receive interest payments at regular intervals until maturity when it is repaid the nominal amount. Creditors of the issuer are also known as debt holders.
Bonds are fixed-income securities because you know from the debt contract the exact amount of cash you can expect in the future, provided you hold the security until maturity.
What are the main characteristics of a bond?
A bond has several characteristics:
- The face value, also known as the par value or principal, equal to the original capital borrowed by the bond issuer divided by the number of securities issued.
- The maturity, which expresses the number of years to wait for the principal to be repaid. This is the life of the bond. The average maturity of a bond is ten years.
- The coupon, that refers to the payment of interest to the creditor at regular intervals. The interest rate paid may be fixed or variable. It is the creditor’s remuneration for the risk taken as a bondholder. The higher the risk, the higher the return, the coupon, will be.
Let us take the example of a company needs to borrow ten million euros in the bond market.
It decides to issue fixed-rate bonds. It divides this issuance into 1,000 shares of €10,000. The face value of each bond is therefore €10,000. The nominal interest rate is set at 5%. Interest payments are made on an annual basis. The annual coupon is then equal to €500 (=0.05*10,000). The maturity of the bond is set at 10 years.
In terms of cash flows, you will receive €500 per year for ten years. At the end of the tenth year, the issuer will pay you a final installment of €10,000 in addition to the interest payment of €500.
What are the different types of bonds?
The bonds issued can be diverse. Their maturity, interest rate and repayment terms vary. In order to better understand them, we must first distinguish their issuer and then the terms of payment of interest.
Types of issuers
There are three main types of issuers: governments, local authorities, and companies.
- Government bonds: A government bond represents a debt that is issued by a government and sold to investors to support government spending. They are considered low-risk investments since the government backs them. So, because of their relative low risk, they are typically pay low interest rates. Country that issues bonds use different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (expire in less than one year), T-notes (expire in one to ten years) and T-bonds (expire in more than ten years).
- Municipal bonds (“munis”): A municipal bond represents a debt that is issued by a local authority (a state, a municipality, or a county) to finance public projects like roads, schools and other infrastructure. Interest paid on municipal bonds is often tax-free, making them an attractive investment option. Because of this tax advantage and of the backing by their issuer, they are also pay low interest rates.
- Corporate bonds: A corporate bond represents a debt that is issued by a company in order for it to raise financing for a variety of reasons such as ongoing operations (organic growth) or to expand business (mergers and acquisitions). They have a maturity of at least one year, otherwise they are referred to as commercial paper. They offer higher yields than government or local authority bonds because they carry a higher risk. The more fragile the company is, the higher the return offered to the investor is. They are divided into two main categories High Grade (also called Investment Grade) and High Yield (also called Non-Investment Grade, Speculative Grade, or Junk Bonds) according to their credit rating reflecting the firm financial situation.
In addition, the way in which interest is paid may vary from one bond to another. For this purpose, there are several types of bonds:
- Fixed-rate bonds: A fixed-rate bond is a bond with a fixed interest rate that entitles the holder to receive interest payments at a predetermined frequency. The interest rate is set when the bond is issued and remains the same throughout the life of the bond. This is the most common type of bond.
- Floating-rate notes: A floating-rate note is a bond with an interest rate that changes according to market conditions. The contract of issuance fixes a specific reference serving as a basis for the calculation of the remuneration. For example, the most common references for European bonds are Eonia and Euribor.
- Zero-coupon bonds: A zero-coupon bond is a bond that does not pay regular interest. They are therefore sold at a lower price than the value redeemed at maturity by the issuer. This difference represents the investor’s return.
- Convertible bonds: A convertible bond is a bond with a conversion right that allows the holder to exchange the bond for shares in the issuing company, the two parties having previously fixed a conversion ratio which defines the number of shares to which the bond gives right.
About the author
Article written by Rodolphe Chollat-Namy (ESSEC Business School, Master in Management, 2019-2023).