Bonds: History, Features and Types
History of Bonds and when they came into Play
Generally speaking, bonds are loans given to the same entity (mostly the central government) where each of the people’s lendings holds a share that attracts interest at specified intervals until the principal amount is repaid at maturity, which is usually after a long time from 20 years and above. Bonds are usually given by the central government in form of treasury bonds. Bonds are used to raising funds for financing day to day activities of an institution. Unlike shares where shareholders own part of the company and may have voting rights over crucial decisions of the firm, treasury bonds or bonds are more of a loan than buying the issuing body. More so, bonds have a fixed interest rate despite the performance of the issuing firm/body. It is said that it is a way for small investors to make money.
The history of bonds is farfetched even before the pre-colonial era. However, there is a time in history that is recorded to be the first time when bonds were traded. According to (Guttmann 19), “one of the most striking features of World War II was the progressively rising trend toward debt financing. The emergence of this debt economy must be traced to the immediate post-war years when U.S. industry and consumers… finally had the opportunity to satisfy their pent-up demand”. The emergency of a superpower needed to produce enough quality goods to the world market which accelerated the need for the money to produce these goods.
Thus, the industries needed money and there emerged debt financing. This encouraged the growth of the industries because money was made available. A lot of small investors also participated in these surety bonds by loaning both the government and other firms which could have not participated. In fact, (Emery 97) indicates that “One of the main functions of a bond market is to provide medium and long term funds to both the private and public sectors. With a receptive bond market, the government can finance its economic development program, which would otherwise be difficult if it were forced to rely solely on current revenues”. It sounds rational to solicit funds in this manner where both the bond issuer and the bondholder benefit from the scheme. It is a win and wins situation.
The other issue is the rationale for a company or a government to raise large amounts of money from small investors while they can borrow directly from the World Bank or even big companies like the pension firm. The reason is simple, the bond issuer has to sit down on a round table with the investors to discuss the terms and conditions whereas, borrowing will make the borrower just accept the lending bodies’ terms.
This may end up being very expensive. It is, therefore, to adapt the model of share capital but make it a definite long-term development. The advantages, in this case, are very enormous as compared to direct borrowing. In bonds, the money borrowed is used first and then it produces the profits which are then paid to the investors. Since the money borrowed as well is huge, the involvement of many people distributes the insurance risk hence, reducing the cost of borrowing.
How Bonds are issued and by who
Bonds are usually issued through a complex process because the amount of money involved is very large. This means that the process may involve several firms like banks and not just one bank but it may include a sharing for several banks. Therefore, the government or large firm must involve an intermediary firm known as the underwriter. This process also requires the services of attorneys or lawyers appointed both by the buyer of bonds and the issuer to draw the terms and conditions of the sale. This agreement is intended to have a fairground for both those who are buying and the issuer. This is brilliant through the complex process of a very large investment plan.
To illustrate the concept of how the process is undertaken, the following example may be good. If the country of Libya needs to borrow $300 million to finance its oil exploration process from the public, it would need to use the central bank of Libya as the underwriter. Then the Central Bank of Libya will get busy issuing the bonds by publicizing and providing the necessary legal forms to be filled by the buyers. The public and large firms like the pension firms and health insurance then participate by first showing their interest through registering for the bonds to be issued in an agreed criterion.
There is usually the price of each bond and the minimum number of bonds that one can buy. This process may take weeks or even months and then the actual allocation is made. Once the allocations are made, the underwriter is no longer involved in the bonds anymore.
According to Thau (10), “bonds are issued by government authorities, credit institutions, companies, and supranational institutions.” They all follow the above-explained procedure that is via an underwriter. Thau (11) further explains that “after the sale, the actual payment of interest, record keeping chores, and so forth are further handled for the issuer by a third party, a fiduciary agent, which is generally a bank that acts as a trustee for the bonds”. Think is so because the bonds involve large amounts of money and consequently, the bonds. Again, the fact that each bondholder is holding a varied number of bonds in a specified long period, it is important to pay somebody to do the work. After all, it is not necessarily the work of the issuing company to handle such work because they lack the capacity.
The issuing process involves biding for the underwriter, drawing of issuance rules, the decision of minimum bond value and the actual sale, the maintenance of the bonds records by the trustees, the payment of the interests, and finally, the payout of the principal amount to the investors is for the sure complex. That is the only way the complex process can be explained. Since one company cannot engage in the whole process, other firms have to chip in at least to offer the services. Each firm’s work expires at its stage for example; the underwriter expires after it has made the actual issuance of the bonds. It is clear though those bonds involve large amounts of money and thus, can only be sold by large institutions of public authorities and the process is just clear.
Features of Bonds
There are various features of the bonds and each of them is just a step in the lifetime of the bonds from issuance to the dissolution (that is the repayment of the principal amount to the bondholder and end of the contract. Fabozzi, et al. (200) lists the following features of bonds, “maturity, par value, coupon rate, accrued interest, provision for paying off a bond, and options granted to bondholders”. Features here have an express meaning that may be construed to the physical properties of something. The term features are used to describe the general properties of bonds as opposed to ordinary and preferential shares. The features are explained below by meaning and importance to all parties.
“The maturity of a bond refers to the date that the debt will cease to exist at which time, the issuer will redeem the bond by paying the amount borrowed.” (Fabozzi et al. 201) The maturity date is usually described as due 12/22/2012.
However, this date may look definite because there are usually provisions for the issuer to alter the term or maturity of the bond. The importance of this feature is that it explains clearly when the contract will end so that the bondholders are aware of how long they will earn interest and when they will get their money back. To the Issuer, it stipulates the time in which it should redeem the bonds and stop paying interests for the bonds sold.
After maturity or mostly the last five years of the life of bonds, investors may start receiving their principal amount together with accrued interest back. In cases where the payment is done during the last five years of the life of the bonds, a mechanism is used to indicate which bond should be redeemed first. There are various ways in which this can be done. The lottery method may be used or by the use of the drawing of lots.
In this way, it may be possible to spread the repayment in five years. It is of paramount importance to work on an exit strategy that one may call it so that the settlement is done amicably leading to full redemption of the bonds. The fact that the whole process requires different services like record keeping, payment of interest, and a final payment of the principal amount, it is clear that the process requires the hiring of different bodies to perform each task. The other tasks that may be unnoticeable but very important are accounting and auditing. All these activities must be coordinated well up to maturity.
Par value, “face value, or principal amount is what is paid to investors when the security comes due or matures, with interest having been paid throughout the life of the security. Generally, when the security matures in one year or more, it is a long-term financial instrument and is called a bond” (Temel 20). When a loan is dispensed to someone, it is expected that the amount loaned is returned in the agreed time and the interest is included in the amount. Bonds as well are money invested by several investors who expect that their money is given back at the end of the bond life. Due to inflation and deflation effects, investors have to be paid more than what they put into the company or government. The actual money that they injected into the bond is what is called the par value of the bond. This money belongs to the investor and it is the one that attracts interest which is also paid to the bondholder.
The coupon rate is simply the interest earned on a bond per year given in percentage. “The government issued long term paper with a 10 percent coupon rate with a maturity of six to ten years” (Sweeney 91) is an example of a coupon rate. The coupon rate is usually indicated with the maturity of the bond. The bond may have the coupon rate indicated as in 10% of 12/22/2012, thus, the maturity and the yearly interest rate are indicated on the bond. The coupon is important in the sense that it helps the bond buyer to know how much interest he/she will be entitled to every year. To the issuer, it helps the firm to calculate how much it is liable to pay at the end of each financial year as interest on bonds. The figure is pegged on the gains the company can make per year on the loaned money.
Accrued interest is simply the yearly interest paid off at the end of the term which is at maturity. The interest may not be paid to the initial owner of the bond in the sense that the seller of the bond forfeits the interest to the buyer. The example by Durden (62) claims that “One $10,000 bond with accrued interest amounting to $27,000” illustrates how the accrued interest of a bond could work. One could call this crudely as plowed back profit although not parse. This could discourage bonds from changing hands several times. To the new holder, even if the time lapses, they would be able to enjoy the last patch of the profits from the bond. Without this, the bondholder may decide to sell the bond when the maturity date is so near that the buyer may not get interested.
Provision for paying off a bond
Lasher (201), when he explains how a company may pay bondholders at the maturity date states that “instead of paying off all the bonds at the maturity date, the company called and retired a few each year during the last five years of the issue’s life”. Thus, the features of the provision for paying off a bond indicate how the bondholders will be paid off when maturity is due. This could be either by paying off after the maturity date or in the last stages of the term, usually five years to maturity. In case of paying off starting earlier than the maturity, the bondholders have to go through a lottery to decide who will be paid off first before the other which will only be fair to bondholders.
This is very essential because it guides the bondholder on when they receive his or her loan back. To the company, these provisions help it to redeem the bonds in time and clear the loan it took from bondholders. In real life, the bond is a long-term investment and it will be very awkward for an investor to wait for those years to gain from his/her investment, therefore, him/her needs to be paid annual interests. These annual interests paid to investors are what is called the coupon rate.
Options granted to bond holders
The investors who buy bonds as investment more often than not find it necessary to withdraw from the contract. But since these are business transactions, there must be amicable ways of pulling out for one reason or the other. Thus, every time bonds are issued, there should be guidelines on how to end the contract. Fabozzi (50) explains this concept that, “when a bond is issued, typically the borrower may not call it for a number of years. That is, the issue is said to have a differed call. The date at which the bond may first be called is referred to as the first call date. Bonds can be called in part or whole”. These are usually clearly stipulated in the issuance of bonds and are referred to as options granted to bond holders.
Types of Bonds
There are a number of types of bonds and this categorization is pegged on the terms and conditions of each bond on sale. Like it was explained earlier, bonds can be offered by a government authority, the government itself, a corporate or even asset backed industries and international bonds. In each case, there are different types of bonds (Duncan 9).
Zero coupon bonds are basically bonds that are sold at lower rate than the par value but do not have annual interest rates. The interest earned is the difference between the par value and the buying value and it is accrued, thus, it is payable on maturity. The advantage with this type of bond is that they have a higher interest rate than other types of bonds.
Fixed Rate is simply a bond with a fixed coupon rate. This type of bond has fewer security risks on interest because it is fixed at the beginning of the bond issue. This type of bond however, is susceptible to inflation and thus may be affected adversely. As opposed to floating rate bonds, the investor is not cushioned over inflation (Yago 98).
Inflation linked bonds are bonds whose principal value is recalculated pegged to inflation. This is designed so as to cushion the investor from loses that may occur due to inflation. In each economy, due to economic environment variables and growth in business, the value of money today may not be the value of money tomorrow thus an arrangement is reached to recalculate the principal value of each bond. Usually periodic coupon value is affected by the inflation state of the economy.
Lottery bond is a type of a bond that can only be issued by a government as an incentive to purchase other bonds. The lottery is just like the ordinary bond but its serial number makes the difference because it will be awarded a higher interest rate. This type of bond has only been sold by three European nations as an incentive for purchase of bonds.
Foreign Currency bonds
As the global markets expand, the foreign exchange market also expands enabling money to be transferred from one economy to the other. When the amount of money required is huge, the sale of bonds may be extended to other economies. Therefore, if the currency in one economy is stronger than the other, buying of these bonds may be of high returns. In short, foreign currency bonds are bonds floated by another economy whereby, one needs to buy the bonds in the home currency. This indicates that the buyer must convert his/her money to the currency of the selling economy.
Bond credit rating and how it matters
Bond credit rating refers to assessing the potential of the issuing body whereby, they are given grading that ranges from ‘AAA’ to ‘D’ that basically describes the quality of bonds a body can offer. Credit rating is simply an indicator of how good an investment is. It is important in the sense that it enables the bond buyer to know what returns to expect when the bonds mature. In most cases, the US government bonds have always scored a ‘AAA’ rate. This rate is the best and hence, investors are sure that they will get the best returns out of their investment (Frank & Harry 78).
How government uses bonds and its features
Due to the fact that a country cannot have shareholders like a company, the government cannot raise money for example a rights issue. However, a government may require large sums of money to run its operations. With this regard, the term shares had to be reengineered to fit the government debt financing needs. The government through treasury bonds can raise the much needed money for income and then pay it off slowly in form of coupon rate and accrued interest with the principal amount. This simply means that the government will not spend money in paying interest for instance, if it requested for a bank loan.
The government in this case has to negotiate terms and conditions of the bond hence, it does undergo unnecessary expenditure. On the other hand, the investors get an avenue of investing through the government and the returns are usually high. Depending on the type of bond bought, the investor may not be stressed about his/her money invested in the economy.
In most cases government bonds are classified into bills, notes and bonds. Whereby, bills are debt securities maturing in less than one year, notes are debt securities maturing in one to 10 years and bonds are debt securities maturing in more than 10 years. In conclusion, debt securities are generally a good investment for small scale investors because they have specific coupon rates and the interest must be paid despite the performance of the issuing firm.
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