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What is a Bond?
In finance and economics, a bond or debenture is a debt instrument that obligates the issuer to pay to the bondholder the principal (the original amount of the loan) plus interest. Thus, a bond is essentially an I.O.U. (I owe you contract) issued by a private or governmental corporation. The corporation "borrows" the face amount of the bond from its buyer, pays interest on that debt while it is outstanding, and then "redeems" the bond by paying back the debt. A mortgage is a bond with a lien on a real estate.
Bonds are securities but differ from shares of stock in that stock is an ownership interest (termed "equity"), but bonds are merely "debt": Therefore a shareholder is an owner, but a bond-holder is merely a creditor.
Each country sets its own rules for issuing and redeeming short and long-term debt and stock. In the U.S. (for example):
- Bonds are long-term loans secured by property rather than short-term loans secured merely by the debtor's promise to pay.
- Interest paid to bondholders receives preferential tax treatment compared to dividends paid to shareholders.
- In bankruptcy, bondholders are paid before short term creditors (including workers who are owed wages) and all creditors must be paid in full before owners receive anything.
Issuing bonds
Bonds are issued by governments or other public authorities, credit institutions, and companies, and are sold through banks and stock brokers. They enable the issuer to finance long-term investments with external funds. The term total volume refers to the number of individual bonds in a bond issue.
Features of bonds
The most important features of a bond are:
- initial value, known as the "par value"
- maturity date - Bond maturity tells when investors should expect to get the principal back and how long they can expect to receive interest payments. The maturity of a bond can be any length of time, although typical bond maturities range from one year to 30 years. There are three groups of bond maturities:
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- Short-term (Bills): Maturities less than 1 year
- Medium-term (Notes): Maturities between 1 and 10 years
- Long-term bonds (Bonds): Maturities greater than 10 years. Most bonds are 30 years or less, but bonds have been issued with maturities of up to 100 years. Some bonds never mature (perpetuities).
- the "coupon" or "nominal yield," effectively the interest rate
- whether the interest rate is fixed or floating
- whether the lender can force the borrower to buy back the bond before maturity (which is often called an embedded put option).
- whether the borrower can pay back the bond at any time before the maturity date (which is called prepayment, or an embedded call option).
The rights of a particular bond issue are specified in a written document, called an "indenture". In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. Those terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bondholders.
Interest is paid on the first "coupon date" and subsequently on coupon dates at regular intervals, assuming the issuer has the
money to make the payments on those dates. If all interest ("coupon") payments have not been made when due, and so are in arrears, the issuer must also pay those back-due amounts when it redeems the bond, in addition to the principal ("face") amount.
Callable
The bond may have a "call" provision that allows the issuer to pay back the debt (redeem the bond) before its nominal maturity date. When there is no such provision requiring a holder to let the issuer redeem a bond before its maturity date, the issuer may offer to redeem a bond early, and its holder may accept or reject that offer.
There are three broad categories of callable bonds.
- A "European callable", one with a European-style contract, can only be called on one specific date.
- A "Bermudan callable" can be called on several different dates (usually coinciding with coupon dates).
- A "US" or "American callable" can be called at any time until the option matures.
The European option can also be considered to be a type of Bermudan option, with only one call date.
Bonds can also carry "put options", which allow the investor to sell the bonds back to the issuer at par value on specified dates.
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Bonds, Money
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