Fixed Income Security – Bonds
Feb 12th, 2012
To start on a lighter note, these are not the covalent or theionic bonds that bring two atoms together. We are talking about a type of fixed incomesecurity.
Just a small background check before we go ahead. We have read about the money market instruments. If we look closely all the instruments like T-Bills, CDs and CPs that we have discussed in the above link are fixed income securities, i.e. interest earned on these securities is known at the onset.
Let’s understand this with an example of a 91 days T-Bill.
You buy a T-Bill of say face value Rs 100 of a maturityperiod of 91 days. It will be available at a discount, say at Rs 90. You willget the face value at the maturity date of this T-Bill, i.e. on the date atwhich the issuer will return the face value of the bill to the investor. Hence,the investor knows the interest amount heis going to earn, i.e. Rs 10 on investing Rs 90 by the time the security matures. Hence we say T-Bill and likewise all the other money market instruments are fixed income securities.
While in case of shares if we see the dividend earned on themis never fixed. It can vary from being zero to some value. These dividend payouts by the corporation keep the investors loyal to the company’s stock. Hence this is an example of variable income.
Now what is the difference between a bond, which is also a fixed income security and theother money market instruments?
Money market instruments are short term instruments, i.e. the maturity period generally lies within 1 year of the issue date. Bonds on the other hand have a longer maturity period generally ranging from greaterthan 1 year to thirty years.
As we go further you will realize that ‘Bonds’ in itself is too big a topic to be covered in a single post. So for this post we will limit ourselves to its definition, and will try and understand the terms used while defining ‘Bonds’. We will also take up the types of bonds.
Bond: A bond isa debt security issued by the borrower/issuer to generate required finances for the corporation by promising interest rate earnings to the investor.
Debt is kind of a loan. It is anobligation on the borrower to return the borrowed amount along with an intereston the amount. A debt security is issued by the government/organization/issuer promising certain interest rate tothe investors/creditors over andabove the amount borrowed.
So from the above definitions it should be clear that when acorporation or the government need funds they can opt to issue bonds and canborrow from the general public to raise finances for new projects, expansion etc promising them to return their cash along with an interest after a certainperiod of time i.e. after the maturity period of the bond.
Before we go on with our discussion over the bonds, it will be beneficial if we first have a look on certain terms that will be used going forward.
- Issue: When an organization/government makes the bonds available to the investors, for them to purchase, it is said to be issuing bonds. The organization/government is the issuer. The issuer will collect the proceedings from the sale of bonds. The investor will receive the invested amount and the interest amount sometime in future.
- Face Value:The value over which interest calculations will be done. It can bedifferent from the price at which the bonds are purchased by the investors. The investor would purchase the bond at or near the face value of the bond. But the interest calculations will be done only on the face value.
- Issue Price:The price at which the bonds are purchased by the investors is the issue price. The issue price is equal or close to the face value.
- Coupons: The interest payment by the issuer to the investors is called a coupon. We will see at alater stage when does a coupon payment is made.
- MaturityDate: It is the date on which the issuer returns the bond’s facevalue to the investor. Here we mention about a different types of bond, a Callable Bond. We will discuss about this type of bond at the end of the post.
These were the few terms which will help us understand thetime line of a bond.
- On the issue date, the investor purchases the bond at the issue price, which might besame or different from the face value.
- The issuer receives the proceeds from the sale and makes the coupon payments which generally happen annually or semi-annually.
- On thematurity date, the issuer pays back the last coupon along with the face value of the bond to the investor.
Suppose face value of the bond is Rs 1000 and the coupon rateis 4%. Now even if the issue price is different from the face value, the couponwill be calculated as 4% of the face value, i.e. Rs 40. On the maturity date the investor would get a total of Rs 1040 (face value + last coupon).
Types of Bonds based on the coupon payment period:
- Vanilla Bond: The example we took above is a vanilla bond. The coupon payments in these bonds aremade at regular intervals.
- Zero CouponBonds: These bonds do not pay any coupons during the lifetime ofthe bond. They only pay the bond’s face value at maturity. So it is apparent that these bonds will be issued at some discount to their face value. This discounted amount will be the actual earning of the investor over the issue price.
- PerpetualBonds: These bonds never repay the face value to the investor but the coupon payments are made indefinitely.
Quite simple isn’t it. We will not go any further but discussone last thing, i.e. the callable bonds which we had mentioned earlier in thepost.
Types of Bonds based onthe maturity date:
- CallableBond: Generally for a bond there is a fixed maturity date. But callable bonds can be called by the issuer on certain specified dates after the issue.
- Puttable Bond:The holder of a puttable can put the bonds back to the issuer on certain specified dates after the issue. The holder has the right to ask for repaymentof the face value.
In case of callable bonds the issuer might repay the facevalue or face value plus some premium because the investor is at risk of bonds being called earlier than the maturity period. This repayment is called the redemption price. It can be the opposite in case of puttable bonds as the issuer is at the risk of being askedfor the repayment earlier than the maturity date.
Here we come to an end of our discussion on bonds for now. But as we have said earlier this is not all. There is much more to come like different instruments, bond’s pricing, valuation, concept of yield to maturity etc.