💵 Bonds (Finance)

Main Topics Covered

What a bond is and how it differs from stocks and money market instruments
How bonds are issued: underwriting, auctions, private placements, tap issues
Core features: principal, maturity, coupon, yield, credit quality, market price, indentures, optionality
Types of bonds by issuer, term, conditions, embedded options, documentation and currency
Bond valuation: price, yield, clean versus dirty price, pull to par, yield curve, over-the-counter markets
Investing in bonds: who buys them, risks, bankruptcy outcomes, and bond indices

📖 What Is a Bond?

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged to provide cash flow to the creditor.

The cash flow usually consists of:
- Repaying the principal (the amount borrowed) at the maturity date
- Paying interest (called the coupon) over a specified amount of time
Timing and amount of cash flow vary with the economic value emphasized, giving rise to different types of bonds.
Interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods.
A bond is a form of loan or IOU.
Purpose of bonds:
- Corporate and other issuers: external funds to finance long-term investments
- Governments: to finance current expenditure

Bonds vs. Stocks

Feature	Bonds	Stocks
Stake in the company	Creditor stake (bondholders are lenders)	Equity stake (stockholders are owners)
Priority in bankruptcy	Repaid ahead of stockholders, but behind secured creditors	Repaid after bondholders
Term	Usually a defined term (maturity), after which the bond is redeemed	Typically remain outstanding indefinitely

Exception: an irredeemable bond is a perpetuity, a bond with no maturity.
Both bonds and stocks are securities.

Bonds vs. Money Market Instruments

Certificates of deposit (CDs) and short-term commercial paper are money market instruments, not bonds.
The main difference is the length of the term of the instrument.
Debt securities with a term of less than one year are generally designated money market instruments rather than bonds.

Other Basics

The most common forms include municipal, corporate and government bonds.
Bonds are very often negotiable: ownership can be transferred in the secondary market.
- Once the transfer agents at the bank medallion-stamp the bond, it is highly liquid on the secondary market.
- The secondary-market price may differ substantially from the principal due to various factors in bond valuation.
Bonds are often identified by their ISIN (international securities identification number), a 12-digit alphanumeric code that uniquely identifies debt securities.

🏦 Issuance

Bonds are issued in the primary markets by public authorities, credit institutions, companies and supranational institutions.

Underwriting (the most common process)

One or more securities firms or banks, forming a syndicate, buy the entire issue from the issuer and resell it to investors.
The securities firm takes the risk of being unable to sell the issue to end investors.
Underwriters charge a fee for underwriting.
Bookrunners arrange the issue, have direct contact with investors and advise the issuer on timing and price.
- The bookrunner is listed first among all underwriters in the tombstone ads commonly used to announce bonds to the public.
- Bookrunners' willingness to underwrite must be discussed before any decision on the terms, since there may be limited demand for the bonds.

Other Issuance Methods

Method	Description
Auction	Usually used for government bonds. In some cases both the public and banks may bid; in others only market makers may bid.
Private placement	Commonly used for smaller issues; avoids the underwriting cost. Bonds sold directly to buyers may not be tradeable in the bond market.
Tap issue (bond tap)	Historical practice: the borrowing government authority issued bonds over a period of time, usually at a fixed price, with volumes sold on a given day dependent on market conditions.

In an auction, the overall rate of return depends on both the terms and the price paid. Terms such as the coupon are fixed in advance, and the price is determined by the market.

⚙️ Features of a Bond

Principal

Also called nominal, principal, par, or face amount.
It is the amount on which the issuer pays interest and which, most commonly, has to be repaid at the end of the term.
Some structured bonds have a redemption amount different from the face amount, which can be linked to the performance of particular assets.

Maturity

The issuer must repay the nominal amount on the maturity date. If all due payments have been made, the issuer has no further obligations to bondholders afterward.
The time until maturity is often called the term, tenor or maturity.
Most bonds have a term shorter than 30 years; some have terms of 50 years or more; historically some had no maturity date (irredeemable).

U.S. Treasury maturity categories

Category	Maturity
Short term (bills)	Under one year
Medium term (notes)	Between one and ten years
Long term (bonds)	Between ten and thirty years
Perpetual	No maturity period

Coupon

The coupon is the interest rate the issuer pays to the holder.
Fixed rate bonds: the coupon is fixed throughout the life of the bond.
Floating rate notes: the coupon varies and is based on a money market reference rate (historically generally LIBOR; after its discontinuation the market has transitioned to SOFR).
Historically, coupons were physical attachments to paper bond certificates; the holder handed in the coupon to a bank in exchange for the interest payment. Today payments are almost always electronic.
Frequency is generally semi-annual (every six months) or annual.

Yield

The yield is the rate of return received from investing in the bond. It usually refers to one of:

Current yield (running yield): the annual interest payment divided by the current market price of the bond (often the clean price).
Yield to maturity (redemption yield in the UK): an estimate of the total rate of return anticipated by an investor who buys at a given market price, holds to maturity, and receives all interest payments and the capital redemption on schedule.
- It is more useful than current yield because it takes into account the present value of future interest payments and principal repaid at maturity.
- It is not necessarily the return the investor will actually earn (as noted by Annette Thau and Frank Fabozzi). It is realized only if:
  1. All interest payments are reinvested rather than spent, and
  2. All interest payments are reinvested at the yield to maturity calculated at the time of purchase.
- The distinction may not matter to buyers who intend to spend the coupons, such as those practicing asset/liability matching strategies.

Credit Quality

The quality of the issue is the probability that bondholders receive the amounts promised on the due dates; it tells investors how likely the borrower is to default. It depends on a wide range of factors.
High-yield bonds (also called junk bonds) are rated below investment grade by credit rating agencies. They are riskier, so investors expect a higher yield.

Market Price

Influenced by the amounts, currency and timing of payments due, the quality of the bond, and the redemption yield of other comparable bonds.
Clean vs. dirty quotation:
- Dirty: includes the present value of all future cash flows, including accrued interest; most often used in Europe.
- Clean: does not include accrued interest; most often used in the U.S.
The issue price is typically approximately equal to the nominal amount. The issuer's net proceeds are the issue price less issuance fees.
During its life the bond may trade:
- At a premium (above par), usually because market interest rates have fallen since issue
- At a discount (below par), if market rates have risen or there is a high probability of default

Indentures and Covenants

An indenture is a formal debt agreement that establishes the terms of a bond issue; covenants are the clauses of that agreement.
Covenants specify bondholders' rights and issuers' duties, such as actions the issuer must perform or is prohibited from performing.
In the U.S., federal and state securities and commercial laws apply to enforcement; courts construe these agreements as contracts between issuers and bondholders.
Terms may be changed only with great difficulty while bonds are outstanding; amendments generally require approval by a majority (or super-majority) vote of bondholders.

Optionality

A bond may contain an embedded option granting option-like features to the holder or issuer.

Feature	Meaning
Callability	The issuer may repay the bond before maturity on call dates (callable bonds). Most allow repayment at par; some require a call premium, mainly high-yield bonds.
Puttability	The holder may force the issuer to repay before maturity on put dates (retractable or putable bonds).
Sinking fund	Part of the corporate bond indenture requiring a certain portion of the issue to be retired periodically.

High-yield bonds have very strict covenants restricting the issuer's operations. To be free of them, the issuer can repay early, but only at a high cost.
Call date categories:
- Bermudan callable: several call dates, usually coinciding with coupon dates
- European callable: only one call date (a special case of Bermudan)
- American callable: can be called at any time until maturity
Death put (survivor's option): lets the beneficiary of a deceased bondholder's estate sell the bond back to the issuer at face value upon death or legal incapacitation.
Sinking fund mechanics:
- The entire issue can be liquidated by maturity; if not, the remainder is called balloon maturity.
- Issuers may pay trustees, who call randomly selected bonds, or purchase bonds in the open market and return them to trustees.

🗂️ Types of Bonds

Bonds can be categorised by issuer type, currency, term, and conditions. The categories are not mutually exclusive; more than one may apply to a bond.

By Issuer and Security Offered

The issuer affects the security (certainty of receiving contracted payments) and sometimes the tax treatment.

Type	Key points
Government (treasury) bonds	Issued by a sovereign national government. Some countries have repeatedly defaulted; other treasury bonds have been treated as risk-free. Backed by the "full faith and credit" of the government. Risk-free bonds are the safest with the lowest interest rate, but most government bonds carry some residual risk, shown by a rating below the top rating and by differing yields among euro-denominated bonds of EU member states.
Supranational bond ("supra")	Issued by supranational organisations like the World Bank; very good credit rating, similar to national government bonds.
Municipal bond	Issued by a local authority or subdivision (city, federal state); backed to varying degrees by the national government. In the U.S. exempt from certain taxes.
Build America Bonds (BABs)	A municipal bond form authorized by the American Recovery and Reinvestment Act of 2009. Interest is subject to federal tax (unlike traditional U.S. municipals) but tax-exempt within the issuing state. Generally significantly higher yields than standard municipals.
Revenue bond	Municipal bond repaid solely from revenues of a specified revenue-generating entity. Typically non-recourse: on default, the holder has no recourse to other governmental assets or revenues.
War bond	Issued by a government to fund wartime military operations and other expenditure; often a low return, bought due to lack of opportunities or patriotism.
Corporate bonds	Issued by corporations.
High-yield (junk) bonds	Rated below investment grade because the issuer may be unable or unwilling to pay interest and/or redeem at maturity; investors expect a much higher yield.
Climate bond	Raises finance for climate change mitigation or adaptation projects. Example: in 2021 the UK government began issuing "green bonds".
Asset-backed securities	Interest and principal backed by cash flows from other assets. Examples: mortgage-backed securities (MBSs), collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs).
Covered bonds	Backed by cash flows from mortgages or public sector assets. Unlike asset-backed securities, the assets remain on the issuer's balance sheet.
Subordinated bonds	Lower priority than other bonds of the issuer in liquidation. Higher risk and usually a lower credit rating than senior bonds.
Social impact bonds	Public sector entities pay back private investors after verified improved social outcome goals, which result in public sector savings from innovative social program pilots.

Subordinated bonds in bankruptcy

The liquidator is paid first, then government taxes, etc.
Holders of senior bonds are paid first among bondholders.
Subordinated bondholders are paid after senior bondholders.

Main examples are bonds issued by banks and asset-backed securities.
Asset-backed securities are often issued in tranches: senior tranches are paid back first, subordinated tranches later.

By Term

Typical categories (numbers may vary by market): under five years is a short bond; 5 to 15 years is medium; over 15 years is long.
Perpetual bonds (perpetuities, "perps") have no maturity date.
- The most famous historically were the UK Consols, some issued in 1888 or earlier; they have now been fully repaid.
- Other perpetual UK government bonds included War Loan, Treasury Annuities and undated Treasuries.
- Some ultra-long-term bonds are virtually perpetuities, since the current value of principal is near zero. Example: a West Shore Railroad bond matures in 2361.
Methuselah: a bond with maturity of 50 years or longer.
- Named after Methuselah, the oldest person whose age is mentioned in the Hebrew Bible.
- Issuance has been increasing due to pension plan demand for longer-dated assets, particularly in France and the UK.
- U.S. issuance is limited: the U.S. Treasury does not issue Treasuries beyond 30 years, which would serve as a reference level for corporate issuance.
Serial bond: matures in installments over time. Example: a $100,000, 5-year serial bond might pay $20,000 per year.

By Conditions Applying to the Bond

Type	Description
Fixed rate bonds	Coupon (usually semi-annual) constant throughout life. Variation: stepped-coupon bonds, whose coupon increases during the life of the bond.
Floating rate notes (FRNs, floaters)	Variable coupon linked to a reference rate such as Libor or Euribor, e.g. three-month USD LIBOR + 0.20%. Recalculated periodically, typically every one or three months.
Zero-coupon bonds (zeros)	Pay no regular interest; issued at a substantial discount to par so interest is rolled up to maturity (and usually taxed as such). Full principal paid at redemption. Example: U.S. Series E savings bonds.
Inflation-indexed bonds (linkers in the US, index-linked in the UK)	Principal and interest payments indexed to consumer prices. Interest rate normally lower than comparable fixed rate bonds. Higher inflation increases nominal principal and coupon. Examples: TIPS and I-bonds.
Other indexed bonds	E.g. equity-linked notes, or bonds indexed on a business indicator (income, added value) or a country's GDP.
Lottery bonds	Issued by European and other states. Interest as on a fixed rate bond, but randomly selected bonds are redeemed on a schedule, some at above face value.

Stripping: a financial institution may separate ("strip off") coupons from the principal of a fixed rate bond, creating a "Principal Only" zero-coupon bond and an "Interest Only" (IO) strip bond.
The UK was the first sovereign issuer of inflation-linked gilts, in the 1980s.

Bonds with Embedded Options for the Holder

Convertible bonds: let the holder exchange the bond for a number of shares of the issuer's common stock. They are hybrid securities, combining equity and debt features.
Exchangeable bonds: allow exchange for shares of a corporation other than the issuer.

Documentation and Evidence of Title

Type	Description
Bearer bond	Official certificate with no named holder; whoever holds the paper can claim the value. Often numbered to prevent counterfeiting, but may be traded like cash. Very risky because they can be lost or stolen.
Registered bond	Ownership (and any later purchaser) is recorded by the issuer or a transfer agent; payments go to the registered owner. A duplicate can be issued if lost, but the bond is not easily transferable. The opposite of a bearer bond.
Book-entry bond	No paper certificate. Issuers (and banks) discouraged paper because physical processing became more expensive; some issues do not offer a paper option at all.

Bearer bonds were historically popular in some countries because the owner could not be traced by tax authorities; after U.S. federal income tax began, they were seen as a way to conceal income or assets.
- U.S. corporations stopped issuing them in the 1960s, the U.S. Treasury in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.
Registered bonds: traceability has a minor effect on prices; a new owner must send the old bond to the corporation or agent for cancellation and issuance of a new bond. They seldom appeared in the market for trading.

Retail Bonds

A type of corporate bond mostly designed for ordinary investors.

Foreign Currency Bonds

Why issue in foreign currency:
- The foreign currency may appear more stable and predictable than the domestic one.
- It gives access to investment capital in foreign markets.
- Proceeds can be used to break into foreign markets, or converted to local currency via foreign exchange swap hedges.
- Foreign issuer bonds can hedge foreign exchange rate risk.
Downside: a government loses the option to reduce its bond liabilities by inflating its domestic currency.
Some foreign issuer bonds have nicknames, such as the samurai bond. They are generally governed by the law of the market of issuance (e.g. a samurai bond issued by a Europe-based issuer is governed by Japanese law) and are used to diversify the investor base away from domestic markets.

📈 Bond Valuation

Price and Yield

The market price is the present value of all expected future interest and principal payments, discounted at the bond's yield to maturity.
That relationship defines the redemption yield, which is likely close to the current market interest rate for similar bonds; otherwise there would be arbitrage opportunities.
Yield and price are inversely related: when market interest rates rise, bond prices fall, and vice versa.

Quoting Prices

Price is usually a percentage of nominal value:
- At par = 100% of face value = price of 100
- Premium = price above 100
- Discount = price below 100
Quoted including accrued interest since the last coupon date: the full (dirty) price. Excluding it: the flat (clean) price. Some markets include accrued interest in the trading price, others add it at settlement.
Most government bonds are denominated in units of $1000 in the U.S. or £100 in the UK. A deep discount US bond priced at 75.26 sells for $752.60. In the U.S., prices are often quoted in points and thirty-seconds of a point.
Short-term bonds such as the U.S. Treasury bill are always issued at a discount and pay par at maturity instead of coupons; this is a discount bond.

Pull to Par

Bonds are not necessarily issued at par, but prices move toward par as maturity approaches (if the market expects full, on-time payment), because par is what the issuer will pay to redeem. This is pull to par.
At issue, coupon and conditions are influenced by current market interest rates, the term and the issuer's creditworthiness. These change over time, so market price varies after issue. Inflation-linked bonds are more complicated.

Yield Measures and the Yield Curve

Current yield: the coupon payment divided by the current price of the bond (the nominal yield multiplied by the par value and divided by the price).
Other measures: yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity.
The yield curve is a graph of the relationship between yield and term to maturity (or the weighted mean term) for otherwise identical bonds.

Bonds with Embedded Options

Valuation is more difficult and combines option pricing with discounting.
The calculated option price is added to or subtracted from the price of the "straight" portion, depending on the option type. The total is the bond's value.
More sophisticated lattice- or simulation-based techniques may also be used.

Bond Markets

Unlike stock markets, bond markets sometimes lack a centralized exchange or trading system.
In most developed bond markets (U.S., Japan, western Europe), bonds trade in decentralized, dealer-based over-the-counter markets.
- Liquidity is provided by dealers and participants committing risk capital.
- The counterparty to a trade is almost always a bank or securities firm acting as dealer.
- A dealer may carry the bond "in inventory" (holding it for its own account, exposed to price fluctuation) or immediately resell it.

💼 Investing in Bonds

Who Buys Bonds

Mostly institutions: central banks, sovereign wealth funds, pension funds, insurance companies, hedge funds and banks.
Insurance companies and pension funds have liabilities of fixed amounts payable on predetermined dates; they buy bonds to match liabilities and may be compelled by law to do so.
Most individuals own bonds through bond funds; still, in the U.S. nearly 10% of all bonds outstanding are held directly by households.

Bonds vs. Equities

Volatility of bonds (especially short and medium dated) is lower than equities, so bonds are generally viewed as safer, but this is only partially correct.
Advantages:
- Less day-to-day volatility than stocks
- Interest payments sometimes higher than general dividend levels
- Often liquid: a large quantity can often be sold without affecting the price much
- Comparative certainty of a fixed interest payment twice a year and a fixed lump sum at maturity
- Legal protection: if a company goes bankrupt, bondholders often receive some money back (the recovery amount), whereas equity often ends up valueless

Risks

Interest Rate Risk

Fixed rate bonds lose market value when prevailing interest rates rise. Because payments are fixed, a lower price means a higher yield.
Reason: investors can get a higher rate elsewhere, perhaps by buying a newly issued bond with the higher rate.
It does not affect interest payments, so long-term investors who want a specific amount at maturity need not worry about price swings.
It matters if a holder might need to sell and "cash out". Conversely, prices rise if rates fall, as from 2001 through 2003.
One way to quantify it is duration. Efforts to control it are called immunization or hedging.
Price changes immediately affect mutual funds holding the bonds, and can be damaging for banks, insurers, pension funds and asset managers (whether or not value is immediately "marked to market").

Credit Rating Risk

Prices can become volatile with the issuer's credit rating, e.g. when Standard & Poor's or Moody's upgrade or downgrade. An unanticipated downgrade makes the price fall.
As with interest rate risk, this does not affect interest payments (provided the issuer does not default), but puts the market price at risk.

Default and Bankruptcy Risk

Bondholders may lose much or all of their money if the company goes bankrupt.
In many countries (including the U.S. and Canada), bondholders are in line for liquidation proceeds ahead of some other creditors, but bank lenders, deposit holders (for a deposit-taking institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much remains. Example: after an accounting scandal and Chapter 11 bankruptcy at Worldcom, in 2004 its bondholders were paid 35.7 cents on the dollar.
In a reorganization or recapitalization (as opposed to liquidation), bondholders may see bond value reduced, often through an exchange for a smaller number of newly issued bonds.

Reinvestment (Call) Risk

A callable bond can be paid off early even though the company agreed to payments for a set period. The investor must find a new place for the money and may not find as good a deal, especially because calls usually happen when interest rates are falling.

Other Risks

Call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk. Some affect only certain classes of investors.

Bond Indices

Indices help manage portfolios and measure performance, similar to the S&P 500 or Russell Indexes for shares.
The most common American benchmarks: Bloomberg Barclays US Aggregate (ex Lehman Aggregate), Citigroup BIG and Merrill Lynch Domestic Master.
Most indices are parts of families of broader indices usable for global bond portfolios, or subdivided by maturity or sector for specialized portfolios.

Bonds: Finance Study Notes