BASICS OF BONDS

BONDS

A bond is a legal document containing an acknowledgement of indebtedness by a company. A bond is a debt instrument which is issued for a period of more than one year. The only purpose of issuing a bond is raising capital by borrowings. It contains a promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of maturity. However it is not necessary that all bonds pay the interest but all bonds require a repayment of principal.

In essence, a bond is an “IOU- I owe You” or loan issued by the borrower.The moment when a borrower buys a bond he becomes the creditor to the issuer. Unlike an equity holder the borrower of a bond does not get any kind of ownership by the issuer of the bond. Hence, the bondholder does not share in the growth of a company. Whereas a bondholder enjoys the preference of getting paid over shareholders. If sufficient financial reserves are not there, it is difficult to get back the principal by the bond holders.

TYPE OF BONDS

Broadly bonds are classified under three categories i.e.

(1)   Government bonds.

(2)   Corporate bonds.

(3)   Zero-coupon bonds.

GOVERNMENT BONDS- 

These are the fixed income bonds.  Govt. bonds represent the borrowing of the govt. as they are backed by the govt. they are 100% risk free. These are again divided under categories.

(1)   BILLS - Debt securities maturing in less than one year.

(2)   NOTES - Debt securities maturing in one to 10 years.

(3)    DEBTS- Debt securities maturing in more than 10 years.

CORPORATE BONDS- 

Corporate bonds represent debt obligation of private sector companies.The company’s earnings ability and debt obligations would determine the bond’s default risk. Corporate bonds are characterized as higher risk yield bonds because there is a higher risk involving of a company than a government bond. A corporate bond can be of short-term, intermediate and long term.

(1)   Short-term-  Such bonds are of less than 5years;

(2)   Intermediate term- is 5-12 years, and

(3)   Long term- over 12 years.

Besides this, corporate bond also includes callable bonds and convertible bonds.

Callable bonds are such types of corporate bonds which are callable and redeemable at any point of time before its maturity period.

And Convertible bonds are those bonds, the borrower of whose can easily convert them into stocks.

ZERO COUPON BONDS (ZCBS)-ZCBs are a special type of bond which does not pay annual interests. It is “issued at discount and repayable at par” type of debt instrument. Because of this nature it is also called as pure discount bonds or DDBs. The return received from a ZCBs expressed on annualized basis is the spot interest rate.

REASONS FOR ISSUING A BOND

Bonds are issued for various reasons by the issuer. The 2 main reasons behind issuing a bond can be.

(1)   TAX SAVINGS

Interest on bonds is deductible while figuring corporate income for calculating income-tax which is not possible for dividends on equity. Thus EPS get increased when financing is through bonds rather than equity or preference shares. 

(2)   GET BENEFIT OF LEVERAGE

The presence of financial leverage in a company is considered by the company’s debt and preference shares. Financial leverage changes the earning before interest and tax (EBIT) and translate it into the larger changes in earning per share (EPS).

  

ADVANTAGES OF BONDS 

(1)   Bonds are attractive to those who are risk averse.

(2)   Bonds are necessary in a portfolio to diversify assets.

(3)   Investors, if properly trained can learn to benefit on the bond price movement and benefit from capital gain.

(4)   Bond " indenture” acts as a proof of its legal existence between the company and bondholder.

(5)   Unlike equity shares, a bondholder enjoys the preference of getting paid first. 

SOME IMPORTANT TERMS RELATED TO BONDS.

(1)   Intrinsic value of the bond- Intrinsic value of bond is equal to the present values of all future cash inflows discounted at the required rate of return.

(2)  Coupon rate- A coupon rate is a fixed nominal rate of interest which is written on the bond certificate and is calculated on the face valve of the bond. It is the rate at which interests are paid to the bondholders at different intervals of time till the date of maturity.

(3)   Current Yield- Current yieldmeasures the annual returnaccruing to the bond holder who purchases the bond from the security marketand sells it beforematurity.

(4)   Yield to maturity (YTM)- Yield to maturity is the compounded rate of return an investor is expected to receive from the bond purchased at current market price from the date of maturity.

(5)   Yield to call (YTC)- Some bonds are callable bonds and are redeemable before the date of maturity at the option of borrower or the issuer at the specific rate.

(6)   Interest rate risk- It refers to variation in returns of bond because of a change in market interest rates.Interest rate risk is composed of two risks:

·         Reinvestment risk

·         Price risk