An Introduction to Financial Bonds

Ever since the global recession hit the world in 2008, it has become something of a style statement to throw around fancy financial phrases – “credit default swaps and collateralized debt obligations escalated the debt crisis!” – or predict the impending doom of a few dozen countries in Europe – “Greece is in for a rough time if it doesn’t implement those austerity measures!” . But in this frenzy of strong words and opinions, let’s get back to the basics for a minute.

Consider a hypothetical instance from the Neolithic era involving two men, Nick and Nate. Nick, a farmer, reached an agreement with Nate, an expert fisherman, to give him some fish in exchange for the rice he’d grown in his paddy field. This barter system continued until the day Nick decided to throw a party at his cave and required some extra fish from Nate. But this entailed Nate going without fish for a day. So Nick proposed that in return he would give Nate an extra bag of rice the following week which would help him compensate for the lost fish. And thus the concept of lending was born.

This entire process has now been transformed to a whole new level. On applying this analogy to today’s financial markets a whole host of new terms comes into play. The extra fish that Nick borrowed is the ‘loan amount’ which Nate lent to him at an ‘interest rate’ of a bag of rice for a ‘loan period’ of one week. Thus the ‘opportunity cost’ incurred by the lender, Nate, in terms of the fish forgone is compensated by the interest amount. However when an individual or entity makes borrowing and lending their business, such a simplified process is no longer being used to its full capacity. Thus in the early 12th century, with financial innovations being churned out by the minute, a new concept of bonds emerged. This was essentially the same as lending but now the interest rate was replaced by the ‘coupon rate’ which implied that the bond holder would now receive periodic coupon payments till the maturity of the bond. Thus a bond is a financial instrument where the bond issuer owes a certain amount of money to the bond holder and is obliged to pay him certain coupon payments periodically.

Features of Bonds

What began as a simple working agreement between Nick and Nate has now evolved into a multi-billion dollar industry. However there are a number of innovative features that have been added to financial bonds. The concept described so far is one of an interest bearing instrument. This can be supported by the following example: A bond issuer issues a bond at a price of $1000 at a coupon rate of 10% for the next 8 years. This implies that the bond holder will receive a coupon payment of $100 for the next 8 years and at the maturity of the bond receives his principal amount of $1000 back. Thus far the arrangement is much the same as a bank loan would work.

However bonds can also be issued in the form of discount instruments. The bond promises to pay a certain amount (face value) at the end of the maturity period along with periodic interest payments. Suppose a bond issuer issues a 10% coupon bond with face value of $1000, at 12.25% yield to maturity and 8 years to maturity, then the bond holder will receive annual interest payments of $100 along with $1000 at the end of the maturity period (8 years). However the price at which the bond is bought is discounted at the yield to maturity. The price of the bond in this case is $889.20 and can be calculated quite easily with the help of a financial calculator. Thus, here the bond is issued at a price lower than its par value ($1000) and this form of trading is known as below par trading. Thus the bond holder receives a capital gain and hence the bond yield is more than in the previous case. This method is mostly employed in case of short-term bonds.

Categorization of bonds

The bond market now boasts of a number of different types of bonds, categorised on the basis of:

  1. The issuer – Corporate bonds, Treasury bonds, Municipal bonds, War bonds, Climate bond
  2. The maturity period – Perpetuities, Serial bonds
  3. Interest rate – Fixed rate bonds, floating rate bonds, zero-coupon bonds, inflation linked bonds
  4. Value of underlying asset – Asset-backed securities (mortgage-backed bonds, CDOs)
  5. Foreign currency bonds

These classifications bring a whole new variety of features among bonds for investors to experiment with. Government securities comprise government bonds or treasury bonds, treasury notes, T-bills etc whose features vary mostly on the basis of their maturity period. Government securities are known as gilt-edged securities and are considered risk-free since they are backed by the government. Despite this, governments have been known to default on their debt as was presented by the case of the Greek government in 2011. In comparison, corporate bonds are more risky as they are based on the credibility of a particular company or organisation. 

Perpetuities are bonds that do not have a maturity period or repayment of principal. They provide fixed coupon payments forever. We have so far discussed cases of fixed interest payments which are decided upon before the issue of the bond. However bonds which offer variable or floating interest rates are also available in the market. In these bonds, the bond holder receives his coupon payment as per the prevailing interest rate in the economy. It follows that as the reference interest rate (LIBOR, bank rate) varies, the coupon rate of the bond will be revised periodically. Zero-coupon or discount bonds offer only the final face value payment with no interim interest payments.

Asset backed securities are those whose intrinsic value depends on the value of the underlying security. Thus mortgage backed bonds depend on the cash flows coming from home mortgages while CDOs (Collateralised Debt Obligations) derive their value from the cash flows coming in through debt repayments or other assets included in the CDO.

Foreign currency bonds like the Eurobond are those bonds which are issued in a currency other than the domestic currency. In case of the Eurobond, the bonds are issued by firms based on the Eurozone in some foreign currency. This gives the issuer the advantage of expanding into the international market and also generating funds in a currency which may be more stable than the domestic currency.

Risks associated with Bonds

Bonds are now standard constituents of the capital market and are meant to finance long term capital investment. Today there is a booming secondary market for the purpose of trading bonds. Thus, as the market expands and becomes more accessible to a larger number of investors and traders, the risks associated with the market become a major concern. Here we list some of the more important risks:

  1. Interest rate risk –If an investor buys a government bond for Rs. 5,000 at a coupon rate of 10% p.a., he will receive coupon payments to the tune of Rs. 500 every year. However as soon as the interest rates in the market go up, investors will rush to buy bonds at the higher coupon rate. The decreased demand for government bonds now results in a fall in their price and hence capital losses for the investor when he resells the bond in the secondary market.
  2. Credit risk – An investor always runs the risk of bond issuers defaulting on their payments. This could be due to financial or managerial instability within the issuing entity but culminates into a risk for the bond holder.
  3. Inflation risk – If the economy is experiencing an escalating inflation rate, then despite prompt receipt of coupon payments, the investor will have reduced purchasing power. The money in hand will now be worth lesser in terms of real assets.
  4. Liquidity risk – In the event of a thin market for bonds with a limited number of buyers and sellers, it might become difficult for a bond holder to sell his bonds thus reducing the liquidity of the instrument. Though there is usually a highly active market for government bonds due to the numerous regulations surrounding them, the market for corporate bonds might present a tricky situation.

Thus there seem to be a myriad of risks surrounding bond trading. However that said, it is a growing market which doesn’t seem to be slowing down. Making well informed choices in the bond market has the potential to yield high gains. Though faith in the bond market may take a hit at times, as was evident in the 2008 financial crisis, the overall outlook is sunny.