This article was first published on May 4, 2014
What are bonds?
A bond is basically a form of IOU which can be issued by governments and corporations when they need capital financing.
An investor (creditor) who purchases a government or corporate bond is lending credit to that entity. Similar to a loan, a bond pays interest periodically (usually in semi-annual terms) and repays its principal at maturity (a bullet payment). In exchange for a bond investment with limited returns, the bondholder obtains a prior claim to the issuer’s assets and a predetermined coupon.
How does a bond work?
Let’s say Company EXPAN wants to build a new plant for $10 million and decides to finance it with debt. EXPAN could issue a bond to raise capital and sell 10,000 bonds with a par value $1,000/bond ($1,000 X 10,000 bonds = $10 million). EXPAN then determines an annual coupon rate (i.e. this is the cost of borrowing to the issuer) which takes into account the prevailing interest-rate environment to ensure that the interest payout is competitive with other comparable bonds. For example, an issuer may wish to sell a 10-year bond with X% annual coupon. When the bond matures at the end of 10 years, EXPAN repays the full principal of $1,000 each back its bondholders.
What drives bond prices in the secondary market?
Bonds are mostly traded over the counter (OTC) through institutional broker-dealers. A bond’s price and yield always move in opposite direction. It is critical to understand that a bond’s market price reflects the present value of its regular coupon payments. Thus, if current interest rates fall, earlier issued bonds become more valuable (price goes up) because they were previously sold in a high interest rates environment with higher coupons. If interest rates rise, the earlier issued bonds may become less valuable (price goes down) because their coupons were relatively lower. Therefore these bonds trade at a discount to its par value. The impact of interest rates movement on bond prices reflect the interest rate risk of the bond.
What are the risks inherent in a bond?
Credit risk: risk that the issuer fails to make fully pay its interest or principal on time.
Liquidity risk: sometimes, an investor might not be able to readily sell his or her bonds due to an illiquid market and might be forced to sell at a lower price to divest the bond position
Reinvestment risk: risk of reinvesting proceeds at a lower interest rate than the initial bond was previously earning.
Inflation risk: when a consumer prices increase at a faster rate than the income payment of a bond, investors might see a negative rate of return as their purchasing power erodes. An investor earning a 5% coupon on his or her bond may face with a real rate of return 1% if inflation grows to 4%.
Value In Action
A bond facilitates the allocation of capital (credit) between borrowers and lenders through the bond market. A bond’s market price is driven by prevailing interest rates with both variables moving in opposite directions. An investor who wishes to purchase a bond should not only look at the interest rate risk but the other underlying risks which a bond might have.
It is always useful to have an idea of what bonds are even as an equity investor as a company’s capital structure will consist of other debt obligations such as bank borrowings and bond issuance.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above
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