A bondholder is any agent who owns a bond. Thus, they are considered creditors of the company or government that issued the bond in question.
A bond represents a loan agreement between an issuer and an investor. The terms of the bond oblige the issuer to pay the borrowed amount ( the principal ) on a specific date. The investor (bondholder) usually earns a certain amount in interest from time to time. Bondholders can buy their bonds both on the primary market (directly from the issuer) and on the secondary market (on the bond market).
In summary, a bondholder is the natural or legal person who has a bond. That is, it is the holder of the bond.
Unlike shareholders, bondholders only enjoy economic rights:
- Right to Receive Periodic Payments. These periodic payments are the coupons and will be received while in possession of the bond.
- Right to receive the principal of the investment on the date and terms set at the time of issuance.
- Preferential right over the assets of the company in the event of bankruptcy. In other words, if the company is forced to sell or liquidate its assets, the money received will go to pay bondholders before shareholders.
Generally, the position of bondholders is considered more secure than that of shareholders because of the pre-emptive right over the assets of the issuing company in the event of bankruptcy.
On the other hand, bondholders also enjoy greater certainty when receiving payments. Both the amount and the dates on which they will receive the principal and interest (coupons) are fixed from the moment the bond is issued. Finally, bondholders can also benefit from appreciation of their securities in the secondary market. These revaluations can be given by the issuer or by the market.
- By the issuer: If the issuer improves its credit condition, that is, increases its ability to meet the loan payment, by reducing the risk of default, the price of the bond will rise and therefore the bondholder could benefit by selling it at the market.
- On the part of the market : If the market interest rate decreases, the return offered by the bond will become more attractive in relative terms, so its listed price will rise.
Although the position of bondholders is in principle more secure than that of shareholders, they are also subject to the financial viability of the issuer. In other words, the bondholder could lose 100% of the invested capital if the company or government in question went bankrupt and could not meet the payment.
On the other hand, the interest rate offered by the bond may not be enough to cover the effect of inflation. If prices rise 4% and the bond pays a 3% coupon, the bondholder has a net capital loss in real terms. The same would occur in the event that the bond is denominated in a foreign currency, and the latter depreciates with respect to the local one.
Finally, bondholders face three more risks if they want to sell their securities on the secondary market before maturity. Whether the issuer’s credit rating deteriorates or interest rates rise, the bondholder will only be able to sell his security for less than the purchase price. Also, if the bond in question is illiquid, its immediate sale could only be executed by accepting a significant discount.
Investment example as a bondholder
A bond investor comes across two investment opportunities, a bond issued by company XYZ and another by country ABC. Both bonds have a nominal value of € 1,000 and a duration of 10 years. After valuing the bonds, the investor obtains both returns. The corporate bond offers 4% per annum and the sovereign 1%.
What is the best option for the bondholder?
To make the best decision, apart from taking into account their tolerance for risk, the bondholder must assess the profitability-risk binomial offered by both investments. In principle, the sovereign bond is safer than the corporate bond, and that is the reason why it offers a lower return. Therefore, the bondholder’s task should be to analyze whether the extraordinary return (risk premium) of 3 percentage points (4% -1%) offered by the XYZ company bond, compensates for the extraordinary risk that it entails.