WHAT IS BONDS: MEANING, OPERATING PRINCIPLE, BONDS VS. STOCKS

What are bonds?

Bonds refer to fixed income instruments that represents a loan, made by an investor to a corporate or government borrower. Bonds can be viewed as an agreement between a lender and a borrower that contains details of the loan as well as the payment. The loan details include the end date when the principal is meant to be due, terms of variable or fixed interest payment made by the borrower and so on. Bonds are useful to a number of bodies including companies, municipalities, states, and sovereign governments. Owners of bonds are usually referred to creditors. Governments and corporations often use bonds as a borrowing tool to fund certain projects that mainly relate to infrastructural development, buying of properties, growing of businesses, research development and in some cases, recruitment of labor. Bonds allow individuals to take up the role of lenders. Markets as well, allow the lenders to sell their bonds to other investors or buy bonds from other individuals.

How Bonds Work and Operate

Bonds, commonly referred to as fixed income securities belong to the three categories of assets that are familiar to investors. The other assets include stocks/equities and cash equivalents. A large number of government and corporate bonds are usually publicly traded while others are privately traded (over the counter) between the borrower and the lender.

Bonds are issued by companies and other institutions to investors when there is a need to raise money to finance new projects, keep operations going or service debts. The issuer issues bond containing the terms of the loan, interest upon payment and period at which the loan must be paid back, i.e., the maturity time. The interest to be paid along with the principal, otherwise called the coupon, is part of the money the bondholder gets for loaning out funds to the issuer.  The face value of the bond is what will be paid back to borrower at the time of bond maturity.

Initial bond prices are usually set at par, sometimes $100 or $1,000 face value per individual bond. Some factors usually influence the actual market price of a bond. These factors include the credit quality of the borrower, the length of time until expiration, the coupon rate verses the general interest rate and the market atmosphere. The credit quality and time to maturity are principal determinants of a bond's coupon rate. When the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate because the bondholder is more exposed to interest rate and inflation risks for an extended period. A bond investor mustn't hold a bond until its maturity date. Bonds can also be repurchased by the borrower if the interest rate declines or borrower's credit improve. 

Characteristics of Bonds

Bonds share some basic characteristics. 

·      The Face value

The face value is the amount of money a bond will be worth at the time of its maturity, and after the bond issuer has calculated his interest in relation to the bond.

·      The coupon/premium rate

The coupon rate refers to the interest rate the bond issuer will pay on the face value of the bond and is expressed as a percentage. For instance, an 8% coupon rate means that bondholders will receive 8% x $1000 face value = $80 every year.

·      Coupon dates

These are the dates on which the bond issuer will make interest payments, at specific intervals, mainly semiannual intervals. 

·      The maturity date

This is the date of maturity of the bond and when the bond issuer will pay the bondholder the face value of the bond.

·      The issue price 

This is the price at which the bond issuer sells the bonds originally.

·      Convexity

Bonds and bond portfolios will rise or fall in value as interest rates change due to changes in the interest rate environment, i.e., the “duration.” The duration describes how much a bond’s price will rise or fall with a change in interest rates.

Bond Categories 

The categories of bonds sold in the market are four in number.

·      Corporate bonds

Corporate bonds are issued by companies. These companies issue bonds instead of taking bank loans for debt financing because bond markets offer more favorable terms and lower interest rates.

·      Municipal bonds

These bond types are issued by states and municipalities and some offer tax-free coupon income for investors.

·      Government bonds

They include those bonds that are issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1–10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "treasuries." 

·      Agency bonds    

These are bonds issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

Varieties of Bonds

There are several varieties of bonds that are available to investors, and are distinguished by the rate of interest (coupon), possibility of being recalled by the issuer and other factors. 

Zero-coupon bonds: do not pay coupons and are issued at a discount to their par value. Example is U.S. Treasury bill. 

Convertible bonds: are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. 

Callable bonds: also have an embedded option but it is different from what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures. 

Puttable bonds: allows the bondholders to put or sell the bond back to the company before it has matured. This can be valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.

How to Buy Bonds

There are a few ways through which bonds can be bought. They include:

·      The U.S. Treasury Department

 New treasury bonds can be bought online by visiting Treasury Direct, to set up an account provided you are above 18 years, and meet all the requirements.

·      Brokerages

 many online brokerages sell treasury, corporate and municipal bonds. Some of these brokers include Fidelity, Charles Schwab, E*Trade and TD Ameritrade.

·      Through Mutual funds or ETFs 

The market price of a bond depends on its characteristics.  Like publicly-traded securities, the price of a bond changes at intervals due to the forces of demand and supply. It is not compulsory for an investor to hold bonds till maturity. At any time, investors can sell their bonds in the open market, however depending on the market situation. The economic interest rate is a factor that influences the prices of bonds. This is because for a fixed-rate bond, the issuer makes an agreement to pay a coupon based on the value of the bond. This means that for a $1,000 par at 15% annual coupon, the issuer is expected to pay the bondholder $150 yearly.

Bond Discounts

The bond discount refers to the amount by which the market price of a bond is lower than its principal amount at the time of maturity. This is called the par value and is often  $1,000. Bonds issued at discounted rates have their market below the face value, thus creating a capital appreciation at maturity because a higher face value is paid when the bond matures. For instance, if a bond has a par value of $1,000 and is trading at $985, the bond discount is $15. Bonds are usually sold at discounts when the market interest rate is more than the coupon rate of the bond.

Investing in Bonds Verses Stocks and which is a better investment option?

Stocks and bonds differ  in terms of their structures, returns, payout and associated risks. Stocks serve as a means of ownership and represent the participation of an investor in a company's growth. The profitability of a stock investment relies on the rising stock price, performance and growth of the company. A bond is a form of contractual debt made between investors and institutions, where a premium or coupon is paid for borrowing. The ability to pay back coupons depends on the borrowers capacity to generate enough cash flow to repay bond holders.

The question of which is a better investment option is quite tricky and should relay on the discretion of the investor. Investingport believes that neither bonds nor stocks are a better investment option because each of them have got merits and demerits which would be outlined below.

Merits of buying stocks over bonds

·      Stocks are capable of generating higher returns on investments than bonds.

·      Stocks are better investment options for investors who are willing to take risks and bear ownership in a given company.

Demerits of investing in stocks over bonds

·      Stocks are a generally more risky investment option than bonds. Stocks are not guaranteed to make returns for the investor, however bonds offer variable investment returns via premium payments. Therefore, getting high investment returns with stocks is possible, but this comes with a greater chance of losing money. Investors who are adversely affected by risks and losses, and also seek periodic payments in the form of premium are better off investing in bonds.