Bond

The issuer of a bond promises to return the money loaned to the buyer of that bond, usually plus previously fixed interest, known as a coupon. That is why it is known as a fixed income instrument.

Bonds are one of the main sources of financing for large companies and public administrations, mainly governments, which through the issuance of bonds materialize the debt, giving their lenders a financial asset.

A bond is an aliquot part of a loan. The issuing organization divides the total debt that it wants to place into small portions, called bonds, so that anyone can lend it money, because the loans are so large that they cannot be granted by a single agent, and therefore, they divide "the contract »of the loan in many small contracts or titles (the bonds), so that the person who owns the bond has a right to be paid back the money that has been loaned plus an interest. The bonds can be transferred in the secondary market and therefore their quoted price varies. The owners or lenders of the bonds are called "holders" or "bondholders."

When buying a bond we are making a loan. The buyer delivers an amount of money, called the principal of the bond, to the company issuing the bond (company that receives the loan). The company undertakes to return to us on a previously established expiration date, the amount we have lent it, plus a previously established interest rate. That is why the bonds are considered fixed income assets, since regardless of how the company does, we will receive at the end of the period the fixed interest to which the issuing company has committed. Although sometimes they have variable interest rates.

Many times they are issued at a discount, that is, the issuing company agrees to give you 100% of the nominal capital on the maturity date of the bond, which is generally 1000 euros. And on the date of issue, in which we deliver the money for the purchase of the bond, we should not lend them 100% if not a little less.

Bond valuation

The present value of a bond is equal to the cash flows that will be received in the future, discounted at the current moment at an interest rate (i), that is, the value of the coupons and the nominal value to date of today. In other words, we have to calculate the net present value (NPV) of the bond:

For example, if we are on January 1 of the year 20 and we have a two-year bond that distributes a coupon of 5% per year paid semi-annually, its nominal value is 1000 euros that will be paid on December 31 of year 21 and its rate of Discount or interest rate is 5.80% per annum (which is 2.859% semi-annually), the intrinsic value of the bond will be:

If we add up all the discounted cash flows, the result is € 986,6058

For more information and examples see bond valuation.

Bond risk

They are often said to be a safe investment, and even government bonds are often referred to as risk-free assets. Although it is true that it is one of the safest investments we can make, we must distinguish two types of risk in bonds:

• Credit risk: It is the possibility that the issuer of the bond cannot take charge of the repayment of the loan.
• Market risk: Possibility that the price of the bond will decrease due to variations in market interest rates.

Bonus types

There are a great variety of bonuses according to their characteristics:

First of all we must distinguish between public or private bonds:

• State Bonds: Securities issued by the public Treasury of a country in order to finance the general state budgets.
• Corporate bonds : These are bonds issued by companies with the objective of financing their activities.

We must also distinguish between bonds based on their credit quality. Although the scale is quite broad and depends on the rating agencies, there are usually two types of bonds:

• Investment grade bond : They have an investment grade credit rating, which means that they have high credit quality and therefore a low risk of default. The minimum payment capacity to be considered investment grade for Moody’s is the Baa rating and for S&P and Fitch it is BBB.
• High-yield bonds: They have a high-yield credit rating, which means that they have low credit quality and therefore a high risk of default.

It is important to distinguish the coupon type of the bond and if it distributes coupons. According to this we distinguish three types of bonds:

• Fixed coupon bonds: This type of securities periodically distributes a fixed coupon. For example 5% per year. They are normally distributed semi-annually. So if a bond with a nominal 1,000 euros has a fixed coupon of 5%, it will distribute 25 euros every six months.
• Zero coupon bond: This type of security does not pay interest until the maturity date, that is, it pays the interest together with the loan amount at the end. In compensation, its price is lower than its nominal value, that is, it is issued at a discount, which gives the principal a higher return.
• Floating coupon bond: These are securities that provide their interests at a floating rate, linked to the evolution of a money market interest rate (Euribor, Libor …) plus a differential. Example: Euribor + 2%.

Depending on whether they have options or not:

• Bonds without options: Also known as bullet bonds. They are bonds that do not have any built-in option. They are the common bonds.
• Option Bonds: Bonds have built-in options.
  • If they have a call option they are known as callable bonds, the issuer has the right to repurchase the bond.
  • If they have a put option on putable bonds, the buyer has a put option on the bond.
• Securities issued by a company (with high capital), which have one or more warrants incorporated in the title in order to lower the interest rate to which the company is going to submit and allow the holders an early amortization of the bond or its conversion in shares.

Other characteristics of the bonds:

• Convertible bond: Its holder has the option to exchange it for shares when there is a new issue at a fixed price. Due to the possibility of this convertibility, the coupon or interest of the convertible bond is lower than it would have without the conversion option.
• Exchangeable bond : It is similar to the convertible, but can be exchanged for existing shares.
• Cash bonds : These are securities issued by a company, which will repay the loan at the fixed maturity.
• Strips : Some government bonds are "strippable", or divided, that is, the value of the bond can be segregated in each of the payments that are made, distinguishing the interest payments (coupons) and the payment of the principal, and negotiate them separately. Example: Thus, from a 5-year bond, 6 strips could be obtained: one for each annual coupon payment, and a sixth for the principal, after 5 years.
• Perpetual debt bonds : These are those that never return the principal, but pay interest (coupons) for life. They are the most sensitive to variations in the interest rate, since their price depends entirely on the interest rate.