Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents.
Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
The initial price of most bonds is typically set at par, usually Rs.1000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.
Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium Rs. 1,090 and another investor buys the same bond later when it is trading at a discount for Rs. 980. When the bond matures, both investors will receive the Rs.1,000 face value of the bond.
The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 8% coupon rate means that bondholders will receive 8% x Rs1000 face value = Rs. 80 every year.
Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semi-annual payments.
The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
The issue price is the price at which the bond issuer originally sells the bonds.
Two features of a bond—credit quality and time to maturity—are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.
Credit ratings for a company and its bonds are generated by credit rating agencies like CRISIL, ICRA,CARE. The very highest quality bonds are called “investment grade” and include debt issued by the Government and very stable companies. Bonds that are not considered investment grade, but are not in default, are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.