By Chloe Rana
What is a bond?
A bond is a fixed income instrument that represents a loan between an investor (bondholder) and a borrower (bond issuer). They are most commonly used when a company or government need to finance and expand a project or operation.
How do bonds work?
When a bondholder buys a bond, they are essentially lending the issuer money. In return, the issuer pays a rate of interest and repays the principal (the amount of money borrowed) when the bond matures. This is known as a coupon. Bondholders often resell the bonds to other investors, by publicly trading on exchanges or selling them privately, before the maturity period ends. As a result, the bond appreciates and depreciates in value until it matures.
Characteristics of Bonds
Maturity: The date when the principal is paid to investors and the company’s bond obligation ends. The maturity can be classified in three ways: short term, medium term and long term. In the short term, bonds mature within one to three years. In the medium term, they mature over ten years and in the long term, maturity is over an even longer period of time.
Secured Bond: Ensures that the bondholder will not lose any money if the bond issuer cannot repay.
Unsecured Bond: The asset is not collateral on the loan, meaning the interest and principal are only guaranteed by the bond issuer.
Liquidation Preference: When a company enters liquidation, the liquidation preference determines who gets paid first and how much they get paid.
Coupon: Represents the interest paid to bondholders. Once the coupon has been paid, this marks the end date. It is usually paid annually or at fixed dates throughout the year.
Tax Status: Tax-exempt bonds (usually government bonds) have a lower interest rate than others.
Callability: The bond issuer redeems their bonds early before maturity at the issuer’s discretion.
Types of Bonds
There are four main types of bonds: US treasuries, government bonds, municipal bonds and corporate bonds. Most bonds vary depending on several factors such as, who issues them, the maturity, interest rate and risk.
These bonds are issued by the US Government and so they are generally the safest bonds to invest in. This is because the interest payments are made on time and they pay back what they owe you.
Other governments often issue bonds as well to fund a variety of schemes and pay their employees. Similar to US Treasuries, government bonds are considered to be very safe to invest in, however, countries with less stable governments involve higher risks.
Also known as ‘muni bonds’, these bonds are issued by counties, states and other municipalities. They are often issued when funding is required to invest in infrastructure, such as hospitals and airports, and these bonds are exempt from taxes.
Corporate bonds are issued by companies and have the highest risk associated with them. However, because they are riskier than government bonds, bondholders will earn a higher income because these corporate bonds are associated with higher interest rates.
How is a bond issued?
There are four stages: pre-launch, launch and roadshow, issue and post-issue.
First, the bond issuer communicates with the bank and explains its need for finance. If the bank cannot assist with the financing, then bonds are generally issued if appropriate. However, before a bond is issued, the issuer needs to consider what type of bond to issue and how to structure the issue. At this stage, a lead manager is allocated to help with the process and both they and the issuer instruct their lawyers.
During the launch and roadshow stage, the lead manager presents and promotes the bond to potential investors. The actual issuing of the bond involves two stages: signing and closing. The signing stage mainly involves signing the prospectus (a document that provides information to investors about the bond issuer and how the bond will be used) and the subscription agreement (a conditional contract between the issuer and the managers). During the closing stage, the remaining documents are signed by the relevant parties and the bonds are transferred to the bondholders.
The post-issue stage involves the issuer paying interest to the bondholders until maturity is reached.
What are the advantages of bonds?
There are two main advantages of bonds: secured income and profit on resale.
Bonds are renowned to be safe investments meaning they are usually a good way to earn income, especially if the bonds are secured. Bondholders receive both interest payments and the full principal if they do not resell the bond.
Profit on Resale
The liquidity of bonds allows bondholders to sell them if the price has risen, whilst allowing investors to buy them if there has been a price decline.
What are the disadvantages of bonds?
Whilst bonds are generally safe, there are several risks involved. These risks involve interest rates, credit, inflation, reinvestment and liquidity.
Interest Rate Risk
Due to the relationship between bonds and interest rates, when interest rates rise, the value of bonds decrease and vice versa. Whilst these fluctuations are expected, if the interest rate changes significantly then this heightens the risk of loss. If interest rates significantly decline, then the bondholder may face the issue of prepayment. This is where the bond issuer simply repays the principal early because there is an incentive to do so, therefore, the investor receives a low interest investment. Equally, if interest rates significantly increase, then the investor will be left with a bond yielding below the market rate.
Credit risk involves the bond issuer not making the principal or interest payments on time, or even worse, at all. If the company has more income then debt, then it is usual safe for the investor to buy bonds, however, if the opposite is true then this is where there is a credit risk involved.
Since bond interest payments are fixed, inflation can cause their value to deteriorate. A higher risk is involved when there is a greater time to reach maturity. However, if deflation occurs, then bondholders will receive a considerably higher income.
Reinvesting the income from bonds can pose several risks. Investors cannot predict what the interest rate will be in the future and therefore will not know when the right time is to reinvest the money. If interest rates are low and the bondholder reinvests his income at this time, then he will potentially lose a considerable amount of money because a lower interest rate will generate lower returns.
Whilst bonds are generally less liquid than stocks, there is still a risk involved. If the bondholder trades them, then they will generally have to sell them at a lower price than expected.
Veragold Mining Company (2020): The company needed to support the construction of the mine, resulting in a two-tier bond structure being implemented. The first tier was connected to the gold price; the company would pay the difference between the current and base gold price or the 5% annual return promised to investors, whichever was higher. The second tier involved the exchange of debentures (a long-term unsecured bond) of gold. Investors who held bonds over €5 million received 1oz gold for every debenture they gave back to Veragold.
Argentina v the Hedge Funds (The Argentinian Bond Default 2014): This default stemmed from 2001, the last time Argentina defaulted on its debts. While most of its creditors exchanged their defaulted debt in 2005 and 2010 for new securities, a few creditors (the Hedge Fund, NML Capital) decided to take the cheap defaulted debt in order to receive payment of the full principal plus interest in New York courts. The pari passu clause in the documentation about the original bonds meant that all creditors were entitled to equal pay; therefore, the judge in New York ruled Argentina must pay NML if they were going to pay the creditors who held the exchanged bonds. Thus, Argentina was forced to pay out $1.3 billion plus interest to the hedge fund.