What are Bonds?
Bonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period.
What is an Indenture?
An indenture is a binding contract between an issuer and bondholder that outlines the characteristics of the bond. It typically includes:
- Date of maturity
- Interest payment dates
- Whether it is convertible or callable (or neither)
- Terms and conditions
Yield/Yield to Maturity (YTM) – The annual rate of return of a bond that is held to maturity (assuming all payments are not delayed).
Principal (or Face Value) – The initial amount of money invested in the bond.
Maturity – The date that the bond expires, when the principal must be paid to the bondholder.
Coupon Rate – The interest payments that the issuer makes to the bondholder. They are typically made semi-annually (every six months) but can vary.
Default – When an individual or entity cannot pay a creditor the pre-specified amount of interest or principal (based on a legal obligation), the person or entity may default, allowing the debtholder to claim their assets for repayment.
What are Par, Premium, and Discount Bonds?
Par Coupon rate = Yield
Premium Coupon rate > Yield
- Investors will pay a premium (higher price) for a bond that offers a higher coupon rate than the market yield.
Discount Coupon rate < Yield
- Investors will pay a discount (lower price) for a bond that offers a lower coupon rate than the market yield.
Examples of Bonds
1. Company A issues five-year bonds on January 1, 2018, which cost $100 each and pay 5%. The YTM is 6%.
What is the yield?
- The yield to maturity (YTM) is 6%.
What is the principal?
- The principal is $100.
What is the maturity?
- January 1, 2023 (the maturity date is in five years from the issue date).
What is the coupon rate?
- The coupon rate is 5%.
2. Company B issues two-year notes on March 1, 2018, which cost $500 each and pay 6%, with the first payment made six months after the issue date. The YTM is 6%.
Which dates will the bondholder be paid?
- September 1, 2018
- March 1, 2019
- September 1, 2019
- March 1, 2020
How much will they be paid on each date?
- September 1, 2018: $500 * (6%/2) = $15
- March 1, 2019: $500 * (6%/2) = $15
- September 1, 2019: $500 * (6%/2) = $15
- March 1, 2020: $500 * (6%/2) + $500 = $515
*Note: 6%/2 because the coupon rate is annual but is paid semi-annually.
*Note: Last payment includes the principal.
3. A bond with a 5.5% yield is offering a 6% coupon rate. Will this bond’s price be higher or lower than the principal?
- Higher, because it’s a premium bond (investors will pay a higher price for the higher rate).
The following are examples of government-issued bonds, which typically offer a lower interest rate compared to corporate bonds.
1. Federal government bonds
The reduced yield is attributed to the federal government’s ability to print money and collect tax revenue, which significantly lowers their chance of default. The U.S. government’s debt is considered risk-free for this reason.
2. Treasury bills
- Maturity < 1 year
3. Treasury notes
- Maturity between 1-10 years
4. Treasury bonds
- Maturity > 10 years
5. Zero-coupon bond
Zero-coupon bonds make no coupon payments but are issued at a discounted price.
6. Municipal bonds
Bonds issued by local governments or states are called municipal bonds. They come with a greater risk than federal government bonds but offer a higher yield.
Examples of Government Bonds
1. The Canadian government issues a 5% yield bond that only pays at maturity. What type of bond is this?
- A zero-coupon bond (discount bond)
2. The U.S. government issues a 2% bond that matures in 3 years and a 3.5% bond that matures in 20 years. What are these bonds called?
- 2% bond: Treasury note (maturity is between 1-10 years)
- 5% bond: Treasury bond (maturity is more than 10 years)
Corporate bonds are issued by corporations and offer a higher yield relative to a government bond due to the higher risk of insolvency. A bond with a high credit rating will pay a lower interest rate because the credit quality indicates the lower default risk of the business.
1. Convertible bond
A company may issue convertible bonds that allow the bondholders to redeem these for a pre-specified amount of equity. The bond will typically offer a lower yield due to the added benefit of converting it into stock.
2. Callable bond
Callable bonds may be redeemed by the company before the maturity date is reached, typically at a premium. It can be beneficial for a business operating in an environment where interest rates are decreasing because the firm can reissue bonds with a lower yield.
3. Investment-grade bond
A bond with a high credit rating (minimum of “Baa” by Moody’s) is considered investment-grade.
4. Junk bond
A junk bond comes with a credit rating of “BB” or lower and offers a high yield due to the increased risk of company default.
Examples of Corporate Bonds
1. Company A issues bonds with a high credit rating (above A) and may be converted to stock. What type of bond is this?
- Convertible investment-grade bond
2. Company B notices a downward trend in interest rates and decides to redeem its low credit rating (CC) bonds with a plan to reissue them at a lower rate. What type of bond are they redeeming?
- Callable junk bonds
3. Company A issues a bond with a coupon rate of 3%, and Company B issues one with a coupon rate of 7%. Which bond will most likely show a higher credit rating?
- The 3% bond because a lower yield typically indicates a lower chance of default, relative to the 7% bond.
Thank you for reading CFI’s guide on Bonds. To keep learning and advancing your career, the following resources will be helpful: