Working of bonds explained

Working of Bonds explained:

Bonds are an important instrument for investors. Synonyms for bonds are ‘obligations’, or ‘fixed income’. In this article we explain the working of bonds and clarify some terminology. Today there are many different types of bonds available on the market.

First we examine a standard bond and examine the parties involved in a bond transaction. Next we explain how bonds work and how bonds can be useful for investors.

What is a bond?

The issuer wants to borrow money from the investor. Such a loan, if issued by a company, is called a corporate bond or a governmental bond if issued by a government. To attract investors the issuer of the bond obliges itself to pay a fixed interest to the investor. This payment is known as the coupon. (Hence the alternative name ‘fixed interest’).

Each bond has a fixed term, called maturity, at maturity the issuer will pay back the loan in full to the investor. Until maturity the issuer will pay the coupons to the investor on a regular basis. Because of this regular payment feature most bonds are suitable for investors who seek a predictable and regular income stream.

Difference between a bond and equity:

Bond holders lend money to the bond issuer. The issuer now has a liability towards the bond holder as result. In case the issuer goes bankrupt it first of all needs to pay its liabilities. Bond holders receive payment on their loans first, before share holders receive any money.  The company distributes any leftover money among shareholders next. Bond holders have a higher priority over capital than shareholders. General investment theory states that most bonds are safer and less volatile than equities. The disadvantage of bonds in comparison with equities is that a bondholder does not participate in the distribution of profits, unlike equities. Finally, remember that bonds always redeem at nominal value at maturity. Therefore take inflation expectations into account for long term bond investments.

Seniority

However, there is a picking order between bonds. Senior bonds are the highest level, followed by normal bond and subordinated bonds rank lowest. Senior bond holders receive payment in full first, next standard bond holders and finally the subordinated bond holders. Therefore the coupon paid to subordinated bond holders is higher. The investor demands compensation for the higher credit risk.

Yield

Another word frequently used in connection with bonds is ‘yield’. Yield represents the effective income an investor receives if he buys the bond and holds it to maturity. The yield can be higher or lower than the coupon. The coupon is fixed, but the price of the bond itself fluctuates. Investors pay more than the nominal value for high quality bonds with an attractive coupon, but demand a discount for bonds which, in their opinion, offer too low yield in comparison to the risk. If the investor pays more than the nominal value his yield will be lower, but if he pays less than the nominal value his yield will be higher. This principle is illustrated here.

Buying good quality bonds during times of stress in the financial system can be a lucrative strategy.