What is a bond? This question can arise when you are planning to invest your money. There are various types of financial assets divided into two categories: fixed income instrument and equity instrument. Equity instruments as you know include stocks, ETFs, Mutual Funds. While fixed income instruments include bonds, treasury bills, commercial papers, certificates of deposit, repurchase agreements, etc. These instruments can be from short to long term and are also called debt instruments. In this article, I’ll talk about bonds, and how you can invest in various types of bonds.
The Definition of Bonds
As mentioned, a bond is a fixed income or a debt instrument. It is issued by various organizations which act as borrowers, while investors park their money in exchange for this instrument. Bonds are issued by the Federal government, corporates, municipalities, States, etc. in order to fund their operations of various kinds of financial projects.
As a bondholder, you can call yourself a creditor. A bond will typically include,
- The bond issuer’s name
- The date of maturity
- The par value (principal value)
- The interest rate or coupon rate which would be fixed or variable and its frequency (quarterly, annually, etc.)
- Currency in which the payment would be made
Types of Bonds
To understand what is a bond, you need to understand the subcategories listed below.
This bond has a feature that the company or the government issuing it can recall at a later date at a fixed price. These bonds are risky for investors because if the price of the asset is increasing and if the company decides to purchase it back at a lower fixed price then the upside potential has to be let go by the investors.
Because the risk is on a higher side, there is a higher interest rate paid to investors. If the organization decides to perform this right early then the investor can receive the principal amount back quicker and can invest in a better investment opportunity.
This is the total opposite of callable bonds. Here, the investor or the bondholder is given the right to sell the bond back to the issuing institution. This gives the bondholder upside benefits because if the prices are decreasing the bondholder can sell it back to the investor company and receive a higher amount in return.
Because here the benefit is given to the investor interest paid on this type of bond is lower.
This type of bond is also known as strips. The reason is that they do not pay any kind of periodic interest which means there is no coupon rate here. The investor gets this bond at a discounted price and can sell it at a par value at a future date of maturity. For example, if you have bought a bond worth $10 at a discounted price of $9 – on the date of maturity, your profit is $1.
Convertible bonds give the bondholder the right to convert the bonds into the common stock. Generally, the maturity of this kind of bond is 5 to 10 years. If the stock price of a company is increasing the bondholder can get an advantage by converting the bond to common stock and getting the upside potential. This also provides bondholders with downside risk protection. Convertible bonds are also known as hybrid security because it is a mixture of debt and equity.
Warrants are a type of convertible bond but here the entire amount is converted into equity on a future date. It provides the holder with the right to buy shares in the company at a fixed price.
Contingent Convertible Bonds
As the name suggests, the contingent convertible bond can be executed depending on certain situations or events. This category of bonds is issued by European banks. For example, you have purchased contingent convertible bonds in a company stating that if the equity price of this company falls below a certain level, you can execute this right to convert your bond to common stock.
Who Issues Bonds?
As I mentioned at the beginning of the article, bonds are issued by various organizations for the purpose of executing certain tasks or raising capital to fund their operations.
These are Government-sponsored institutions that issue bonds in order to fund certain activities like helping students or farmers. The yield on this bond is higher than the government bonds.
Federal Government Bonds
As the name suggests this bond issuance is done by the Canadian government in order to fund government activities. The risk is quite low in this type of bond and thus the return is also lower compared to other bonds.
State, Provinces, and Municipal Bonds
Provinces or municipalities issue bonds in order to take up local projects such as roads, electricity, utilities, etc. These bonds are also safe in nature but a little bit risky than the Federal government Bond.
These bonds are issued by corporations aka private companies in order to finance their operations or other activities like expansion or launch a new product. This bond has higher credit risk and the return is also high.
High Yield Bonds
Now definitely this bond provides a high return but in order to achieve that you are also paying the price of higher risk. This type of bond is usually not given a good crediting rating, thus providing a higher yield to lure investors.
This is a tricky investment because it is a pool of various mortgage loans combined together as a pool of instruments which are again securitized and sold as mortgage-backed securities. You would have heard about the Subprime Mortage Crisis which lead to the Financial Crisis of 2008. Well, mortgage-backed securities played a crucial role in that downfall.
How Does a Bond work?
Bonds are sold at face value which is also known as the principal value of a bond. A bondholder is paid interest on the same till the date of maturity. Though this depends on the type of bond you have purchased; there is no interest payment on zero-coupon bonds.
The interest rate is known as a coupon rate. For example, Jessy buying a government bond having a 2% coupon rate at $10 par value for a maturity of 5 years. It means that Jessy will get 2% interest on the bond having a $10 par value for a period of 5 years. In the 5th year, he will receive the principal amount back.
The Bottom Line
Well, that’s all about bonds. I hope you have got the answer to what is a bond, how they function, and their types. If you are looking for something safe and reliable, then government or state-issued bonds are ideal for you. If you want a higher yield, corporate bonds are a good choice.
One thing you should remember is before investing in any type of risky bond, check the credit rating given by the big three credit rating agencies (Moody’s, S&P Global Ratings, and Fitch). Based on your needs make a decision keeping in mind how this investment may help you to fulfill your future goals. All the best!