A bond is a long term debt instrument or security issued by a borrowing unit under a borrowing agreement. Under the agreement the borrower has to pay a fixed periodical interest. Bonds issued by the government do not have any risk of default. The government honors obligations on its bonds. Bonds of the public sector companies in India are generally secured, but they are not free from the risk of default.
The private sector companies also issue bonds, which are also called debentures in India. A company in India can issue secured or unsecured debentures.
KEY CHARACTERISTICS OF BONDS
Face value: Face value is called par value. A bond or debenture is generally issued at a par value of Rs. 100 or Rs. 1,000, and interest is paid on face value.
Interest rate/COUPON RATE: Interest rate is fixed and known to bondholders or debenture holders. Interest paid on a bond or debenture is tax deductible. The interest rate is also called coupon rate. Coupons are detachable certificates of interest.
Maturity: A bond or debenture is generally issued for a specified period of time. It is repaid on maturity.
Redemption value: The value that a bondholder or debenture holder will get on maturity is called redemption or maturity value. A bond or debenture may be redeemed at par or at premium (more than par value) or at discount (less than par value).
Market value: A bond or debenture may be traded in a stock exchange. The price at which it is currently sold or bought is called the market value of the bond or debenture. Market value may be different from par value or redemption value.
12% BONDS OF 100 EACH ISSUED AT 120 AVAIALBLE IN THE MARKET @ 145.
Investors have many choices when investing in bonds, but bonds are classified into four main types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the federal government.1 It is reasonable to assume that the federal government will make good on its promised payments, so these bonds have no default risk.
However, Treasury bond prices decline when interest rates rise, so they are not free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and on the terms of the specific bond. Default risk is often referred to as “credit risk,” and the larger the default or credit risk, the higher the interest rate the issuer must pay.
Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds, munis have default risk. However, munis offer one major advantage over all other bonds: The interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk.
Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are, of course, exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if you purchase corporate bonds denominated in Japanese yen, you will lose money—even if the company does not default on its bonds—if the Japanese yen falls relative to the dollar.
CORPORATE BONDS
The major nongovernmental issuers of bonds are corporations. The market for corporate bonds is customarily subdivided into several segments, which include industrials (the most diverse of the group), public utilities (the dominant group in terms of volume of new issues), rail and transportation bonds, and financial issues (banks, finance companies, and so forth). In this market, you’ll find the widest range of different types of issues, from first-mortgage bonds and convertible bonds to debentures, subordinated debentures, and income bonds. Interest on corporate bonds is paid semi-annually, and sinking funds are common. The bonds usually come in $1,000 denominations, and maturities usually range from 5 to 10 years but can be up to 30 years or more. Many of the issues carry call provisions that prohibit prepayment of the issue during the first 5 to 10 years. Corporate issues are popular with individuals because of their relatively high yields.
Mortgage Bonds:
These bonds are secured by real property such as real estate or buildings. In the event of default, the property can be sold and the bondholders repaid.
To illustrate, in 2001, Billingham Corporation needed $10 million to build a major regional distribution center. Bonds in the amount of $4 million, secured by a first mortgage on the property, were issued. (The remaining $6 million was financed with equity capital.) If Billingham defaults on the bonds, the bondholders can foreclose on the property and sell it to satisfy their claims.
If Billingham chose to, it could issue second mortgage bonds secured by the same $10 million of assets. In the event of liquidation, the holders of these second mortgage bonds would have a claim against the property, but only after the first mortgage bondholders had been paid off in full. Thus, second mortgages are sometimes called junior mortgages, because they are junior in priority to the claims of senior mortgages, or first mortgage bonds.
All mortgage bonds are subject to an indenture, which is a legal document that spells out in detail the rights of both the bondholders and the corporation.
Debentures:
These are the normal types of bonds. It is unsecured debt, backed only by the name and goodwill of the corporation. In the event of the liquidation of the corporation, holders of debentures are repaid before stockholders, but after holders of mortgage bonds.
A debenture is an unsecured bond, and as such it provides no lien against specific
property as security for the obligation. Debenture holders are, therefore, general creditors whose claims are protected by property not otherwise pledged. In practice, the use of debentures depends both on the nature of the firm’s assets and on its general credit strength. Extremely strong companies such as AT&T often use debentures; they simply do not need to put up property as security for their debt. Debentures are also issued by weak companies that have already pledged most of their assets as collateral for mortgage loans.
In this latter case, the debentures are quite risky, and they will bear a high interest
rate.
Convertible Bonds:
These are bonds that can be exchanged for stock in the corporation. In the United States, most corporate bonds pay two coupon payments per year until the bond matures, when the principal payment is made with the last coupon payment.
Debentures can be divided into the following three categories:
(i) Non convertible debentures – These types of debentures do not have any feature of conversion and are repayable on maturity.
(ii) Fully convertible debentures – Such debentures are converted into equity shares as per the terms of issue in relation to price and the time of conversion. Interest rates on such debentures are generally less than the non convertible debentures because of their carrying the attractive feature of getting themselves converted into shares.
(iii) Partly convertible debentures – Those debentures which carry features of a convertible and a non convertible debenture belong to this category. The investor has the advantage of having both the features in one debenture.
Advantages of raising finance by issue of debentures are:
(i) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax-deductible. Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment.
(ii) Debenture financing does not result in dilution of control.
(iii) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases.
The disadvantages of debenture financing are:
(i) Debenture interest and capital repayment are obligatory payments.
(ii) The protective covenants associated with a debenture issue may be restrictive.
DEEP DISCOUNT BONDS /ZERO COUPON BOND :
Deep Discount Bonds is a form of zero-interest bonds. These bonds are sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is no interest payout during lock in period.
IDBI was the first to issue a deep discount bond in India in January, 1992. The bond of a face value of Rs. 1 lakh was sold for Rs. 2,700 with a maturity period of 25 years. The investor could hold the bond for 25 years.
DDB BONDS OF 2500 EACH ISSUED AT 23% DISCOUNT REDDEMABLE AT PAR IN 5 YEARS.
ALSO KNOWN AS PURE DISCOUNT BONDS.
Floating Rate Bonds:
This as the name suggests is bond where the interest rate is not fixed and is allowed to float depending upon the market conditions. This is an ideal instrument which can be resorted to by the issuer to hedge themselves against the volatility in the interest rates. This has become more popular as a money market instrument and has been successfully issued by financial institutions like IDBI, ICICI etc.
| A bond’s coupon payment will vary over time. These floating rate bonds work as follows. The coupon rate is set for, say, the initial six-month period, after which it is adjusted every six months based on some market rate. Some corporate issues are tied to the Treasury bond rate, while other issues are tied to other rates. Many additional provisions can be included in floating rate issues. For example, some are convertible to fixed rate debt, whereas others have upper and lower limits (“caps” and “floors”) on how high or low the rate can go. Floating rate debt is popular with investors who are worried about the risk of rising interest rates, since the interest paid increases whenever market rates rise. This causes the market value of the debt to be stabilized, and it also provides institutional buyers such as banks with income that is better geared to their own obligations. Banks’ deposit costs rise with interest rates, so the income on floating rate loans that they have made rises at the same time their deposit costs are rising. The savings and loan industry was virtually destroyed as a result of their practice of making fixed rate mortgage loans but borrowing on floating rate terms. If you are earning 6 percent but paying 10 percent—which they were— you soon go bankrupt. Floating rate debt appeals to corporations that want to issue long term debt without committing themselves to paying a historically high interest rate for the entire life of the loan. |
Euro Bonds: Euro bonds are debt instruments which are not denominated in the currency of the country in which they are issued. E.g. a Yen note floated in Germany. Such bonds are generally issued in a bearer form rather than as registered bonds and in such cases they do not contain the investor’s names or the country of their origin. These bonds are an attractive proposition to investors seeking privacy.
Foreign Bonds: These are debt instruments issued by foreign corporations or foreign governments. Such bonds are exposed to default risk, especially the corporate bonds. These bonds are denominated in the currency of the country where they are issued, however, in case these bonds are issued in a currency other than the investors home currency, they are exposed to exchange rate risks. An example of a foreign bond ‘A British firm placing Dollar denominated bonds in USA’.
Euro Convertible Bonds: A convertible bond is a debt instrument which gives the holders of the bond an option to convert the bonds into a pre-determined number of equity shares of the company. Usually the price of the equity shares at the time of conversion will have a premium element. These bonds carry a fixed rate of interest and if the issuer company so desires may also include a Call Option (where the issuer company has the option of calling/ buying the bonds for redemption prior to the maturity date) or a Put Option (which gives the holder the option to put/sell his bonds to the issuer company at a pre-determined date and price).
Callable and putable bonds:
A callable bond is one when the issuer/borrower has an option to retire or redeem the bonds at any time after an initial stipulated period. If the borrowing institutions opts to redeem the debt , the holders have no option but to accept the redemption value. In case the market rate of interest falls below the coupon rate, the callable bond may be redeemed .this will bring benefit to the company. The investor losses an opportunity to stay invested in a high coupon Bond.
A callable bond is one when the holder has an option to redeem the bonds at any time after an initial stipulated period. In case the market rate of interest is greater than the coupon rate, the bond may be redeemed by the lender . This will bring benefit to the Holder.