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WHAT IS A BOND IN FINANCE

Just like our need for a loan to support our education, enjoy our vacations or buy a new car, large organizations need loans to finance their operations, acquire new or expand their markets and increase their innovation base. This need can easily be solved by consulting the financial lending institutions such as banks, stock markets, venture capitalists, among others. Traditionally, these big organizations used to opt for banks to save the situations until there was an introduction of a far more significant option- The Bonds.

Today, the majority of U.S. companies are seeking the attention of the E.U Bond Market investors, as stated in the Fortune.com. In the next few minutes, you will be able to certainly understand what bonds in finance, features or characteristics, categories, types, how they work as well as the risks that are associated on investing in this financial instruments.

is The Big question…

What is a bond?

Bold can be termed as an instrument of indebtedness between the issuer and the holder of the bond. The issuers of bonds are mainly governments and large corporations. Most of the loans from the bondholders (public) issued by the government are used to finance infrastructure, hospitals, roads, and other social amenities.

6 Features of bonds

Six specific details are entailed to the transactions of bonds. These characteristics are common in all bonds across the globe. They are

Coupon Rate

This is the interest rate that the issuer of the bond should pay the bondholder as a percentage of the face value (future value) of the bond. These interest rates are paid at an interval period. The standard is semiannual. For example, a company can issue a bond with face value amounting to $20,000 with a coupon rate of 5% semiannually. That means the bondholder will be entitled to an interest of $1000(coupon rate) semiannually throughout the life of that bond.

Coupon Date

This is the consistent period of the coupon rates usually semiannual. Upon that date, the bondholder receives the coupon rate as described on the terms of the bond.

Maturity Date

This is the end date in which the bond matures requiring the bond issuer to pay the bondholder the face value of the bond as agreed.

Yield

This is the return on investment from the bond. This ROI can be expressed in current yield or yield of maturity.

Principal

This is the amount of money the bondholders are paid by the bond issuer after reaching the maturity date. It is also known as the face amount, par, or nominal. This was the original amount when it was issued.

Credit worthiness

This means how good the issuer can pay the principal at the agreed maturity date to the beholder.

4 Categories of Bonds

The ones sold in the market are of four major categories as explained in details below

Government bond/Treasuries

These are issued by the U.S. Treasury. They are also referred to as treasuries. Treasuries are divided into three depending on the maturity dates, i.e.,

Bills

Bills are government bond that has a maturity date of one year or less.

Notes

These are treasuries with one to 10 years to maturity.

Bonds

They are treasures by the U.S. Treasury that take a maturity date that is more than 10 years.

Corporation Bonds

They are issued by companies to finance their debt. They often prefer this type of loan due to its favorable terms and conditions. Besides, corporation bonds have less interest rate.

Municipal Bonds

These are issued by the municipalities or states commonly with free tax coupons.

Agency

These types of bonds are issued by government-affiliated organizations such as Freddie Mac.

Different types of Bonds

Convertible bonds

The terms give the bondholder the right to exchange the bond with a percentage of shares of the common stock of the bond issuer. Also known as hybrid securities, these bonds combine the characteristics of debt and equity.

Floating rate notes

They have variable coupons that are attached to reference interest rates.

Fixed rate bonds

The interest rates of these bonds remain constant throughout the life.

Zero coupon bonds

These one, they do not pay regular interest because they are issued at a standard discount to par value.

Exchangeable bonds

These can be exchanged only with the company’s shares rather than payments by the issuer.

How Bonds work

Credit institutions, public authorities, supranational institutions, and companies issue bonds in the primary market through a process is known as underwriting. After underwriting, Securities agents, firms and banks for a syndicate that issue the whole bond from the issuer and reissue it to potential investors (bondholders).

Contrary, the government bonds are sold in an auction. This action gives a chance for the public, banks, and market makers to bid for the bonds. The rate of return is determined by the price paid and the terms of the bond. Some terms such as coupons have their prices determined by the force of demand and supply in the market.

In the act of underwriting, the underwriters charge a small fee to enable smooth operation the process. An alternative to underwriting that is commonly applied in the issuing of small bonds is the private placement bond which eliminates or reduces the cost of issuing since the bonds are issued directly to the buyer.

Risks of investing in bonds

Despite bonds having a higher return on investment, numerous risks are associated with these types of loan transactions. These risks include:

Inflation Risk

Sometimes, the government may enact policies that may lead to inflation. This risk can be prevalent especially if you do not have a variable bond that has a built-in-protection.

Credit risk

This is a risk that can occur when the bond issue is unable to pay the bondholder his or her principal.

Reinvestment risk

It is a wish by every investor to get period interest amount. However, for some such as zero-coupon bonds, which does not give a sure return on reinvestments of these kinds of bonds.

Liquidity Risk

Bonds have less liquid, which means that one may have quite a heavy tome selling it a price of a top dollar. With this in mind, it is not advisable to restrict the buying of individual ones.

Conclusion

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