:: Collaborations ::

:: Bond - A Primer ::

Fixed income investing is a closed contract as against an open-ended contract in equity investing. You as a fixed income investor always enjoy a prior claim on the cash flows and assets of the borrower. In effect, you have a priority over equity shareholders with regard to both - payment of interest as well as principal. But in exchange of obtaining this priority, you have to give up the right to enjoy any profits made by the borrower from your money, over and above the promised rate of interest.

Bond

A bond, which is a part of Fixed Income investments, is just an organization's IOU; i.e., a promise to repay a sum of money at a certain interest rate and over a certain period of time. In other words, a bond is a debt instrument. Other common terms for these debt instruments are notes and debentures. Most bonds pay a fixed rate of interest (variable rate bonds are slowly coming into use also) for a fixed period of time. Simply put this is money which you lend for a fixed period at a fixed rate. Your returns are fixed at the time of lending and you give up the right to participate in the earnings of the borrower for the safety of regular returns.

Debentures

This is a financial instrument, which represents a contract between a lender and a borrower (normally a company) confirming the amount borrowed, the tenure of borrowing, the interest payable and the assets charged against the borrowing. They carry a fixed interest rate which could be payable at specified periods (quarterly, half-yearly, annually). Debentures could be for varying and the tenure of the debentures is normally fixed at the time of the issue, but recently some innovation in the form of call and put options have been introduced

Fixed Deposit

Fixed deposits are similar to a debenture/bond in terms of both being for a fixed period and a pre-determined interest rate. However, unlike debenture/bonds, fixed deposits are always unsecured.

Debentures are normally secured against the assets of the borrower. Though, there is no bar on the issue of unsecured debentures, by and large, most of the debentures issued by companies are secured. In order to lend credibility and satisfy guidelines of securities regulatory bodies all debentures are rated by credit rating agencies.

An investor could buy debentures either from the primary market i.e. subscribe to the public issue of a debenture or buy it from the secondary market i.e. buy it through the exchanges. Most of the debentures which, are issued to the public are listed and hence do allow the investor to sell the same before maturity.

Who issues the Bonds?

Governments and other sovereign bodies Banks and Development Financial Institutions PSUs Private sector companies Government or quasi government owned non-corporate entities

Companies of all sizes issue corporate bonds. Bondholders are not owners of the corporation. But if the company gets in financial trouble and needs to dissolve, bondholders must be paid off in full before stockholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy.

A bond with a maturity of less than two years is generally considered a short-term instrument. A medium-term note is a bond with maturity between two and ten years. And of course, a long-term note would be one with maturity longer than ten years.

Price of the Bond

The price of a bond is a function of prevailing interest rates. As rates go up, the price of the bond goes down, because that particular bond becomes less attractive (i.e., pays less interest) when compared to current offerings. As rates go down, the price of the bond goes up, because that particular bond becomes more attractive (i.e., pays more interest) when compared to current offerings.

The price also fluctuates in response to the risk perceived for the debt of the particular organization. For example, if a company is in bankruptcy, the price of that company's bonds will be low because there may be considerable doubt that the company will ever be able to redeem the bonds.

On the redemption date, bonds are usually redeemed at "par", meaning the company pays back exactly what the bondholders paid it way back when. Most bonds also allow the bond issuer to redeem the bonds at any time before the redemption date, usually at par but sometimes at a higher price. This is known as "calling" the bonds and frequently happens when interest rates fall, because the company can sell new bonds at a lower interest rate (also called the "coupon") and pay off the older, more expensive bonds with the proceeds of the new sale. By doing so the company may be able to lower their cost of funds considerably.

Who buys bonds?

People who are very adverse to risk and do not want to invest in risky instruments such as shares and mutual fund units usually buy the bonds. Those who want a steady stream of cash flow subscribe to the bonds that pay regular interest monthly/quarterly/half yearly. Some type of bonds also provide income tax benefits to the subscribers e.g the bonds whose proceeds are invested in Infrastructure projects so the people falling in tax brackets subscribe to these Tax saving bonds to avail tax benefits.

Apart from individuals, corporate bodies also make their investments in bonds to earn the regular interest from a relatively safe investment. They are:

Banks, Insurance companies, Provident funds, Mutual funds, Trusts, Corporate treasuries, Foreign investors.

The Bonds of financial insitutions have become popular because of the security and tax rebate features. Now with the change in the taxability of the dividend given by the Mutual funds, the investors are also moving to investments in Mutual Funds.

When it comes to making investment decisions, stocks often grab the lion's share of our attention while fixed income securities-which may seem less complex or risky-may be selected more hastily. Moreover, bonds and money market securities may be chosen on the basis of yield alone, without considering other important characteristics such as credit quality, maturity, and potential price volatility.

While bond prices typically do not swing as widely as stock prices, income-oriented investors-like growth-oriented equity investors-should balance their return expectations with their tolerance for risk.

What are Bonds?

Bonds are debt obligations issued by corporations, states, municipalities and government agencies. The insurer agrees to pay the holder interest on a semiannual basis and then repay the principal when the bond matures-usually 20 to 35 years in the future. Investors can purchase bonds when originally issued, or later in the bond market. The face value (par value or denomination) of a corporate bond is typically $1,000; a municipal bond is usually $5,000.

Bonds are called "fixed-income" securities because they pay a fixed interest rate-so long as the company is solvent. However, bond values are not fixed-an important fact overlooked by too many novice investors! Bond prices are quite sensitive to prevailing interest rates. They will fluctuate above or below their par (face) value, in opposite directions to interest rates.

Historically, bonds were considered a good and safe investment for retirees, widows, orphans and institutional investors. Investors bought bonds, clipped the coupons to collect their interest every six months and sleep well. Bonds still attract these types of investors, but, because of junk bonds and takeovers, the character of bonds changed in the 1980s.

In earlier years, before LBOs, junk bonds and Chapters 7 & 11 bankruptcies, strict covenants of the bond contracts guaranteed bondholders their payment when due. Today, these covenants may have broad interpretations that definitely are not advantageous to the bondholder. Bondholders of takeover stocks sometimes have watched the common shareholders clean up when a takeover is announced, while their bonds drop to 10 or 15 percent of their original par value.

Big investment banks or brokerage firms chasing big takeover fees are to blame. They write the covenants to benefit their big clients, not you, the bondholder. Banks tell their brokerage clients how solid and safe they are, while their own bond investment departments are assisting the takeover artists in deals that can drive the bonds to near-zero worth. Listed below are some of examples of deals or situations that were not in bond holders best interests: After defaulting on over $2 billion in bonds, the Washington Power Supply System (WHOOPS) is planning to issue more bonds.

In the late 1980s RJR Nabisco issued bonds. A few months later, RJR management initiated a takeover plan with the assistance of Shearson-Lehman and the bonds dropped 10 percent in value. Interestingly, Shearson was one of the underwriters for the bonds.

When Texaco went into bankruptcy (because of the Penzoil lawsuit), it delayed making interest payments to the bondholders. The odd part is that once Texaco emerged from bankruptcy, its superior credit rating remained intact.

Covenants

Provisions in the legal agreements on loans, bonds, or lines of credit. Usually written by the lender to protect its position as a creditor of the borrowers.

Compiled by Henry Tang.

Back for more