Meaning of Bonds/Debentures
Bond is an interest bearing promise to pay periodic income regularly and repay specified sum of money borrowed (known as principal) at particular date. In other word, bond or debenture is a debt security which simply refers to the claim on series of periodic income. The company pays interest annually at predetermined coupon rate and refund face value at the end of the maturity period. For example, A company issues 10% coupon bond at a par value of Rs.1000 with 10 years maturity. In this example, investors can claim Rs.100 (10% of Rs.1000) per bond as a interest for next 10 years and at the last of maturity period they also claim invested amount.
In India, people often use bond and debenture interchangeably but in US and other Western countries bonds are considered more secure as it is backed by collateral. On the other hand, debenture is only backed by borrower’s promise.
Features of Bonds
Bond is a type of financial securities which is regarded as a debt for the company that must be redeemed (in case of redeemable bonds) at the time of maturity period. The company pays interest annually at predetermined coupon rate and refund face value at the end of the maturity period. Some of the main features of bond are as follows:
1. Face value
Face value of bond is the price at which the bond is returned at the maturity. Generally, the face value of bond is Rs. 1000. The bond is either issued at face value or discount or premium. If the bond is issued at a price lower than it’s face value then it is said that the bond is issued at discount and if higher price then it is said that the bond is issued at premium.
2. Coupon rate
It is the fixed rate of interest that the company pays to the bond holders or debenture holders annually, semiannually or quarterly until it’s maturity. It is predetermined as per the market interest rate and remains fixed during the life of bond. Coupon rate is not affected by change in market interest rate and market price of bond. Let’s be clear from this example, A company issued 8%, 10-years bond at par value of $1000.
In this example, the rate 8% is the coupon rate at which the bond holders get annual payment of $80 (8% of $1000) until it’s maturity of 10 years.
3. Coupon Interest /Coupon Amount
It is the amount paid to the bond or debenture holders annually, semiannually or quarterly until it’s maturity. It is calculated by multiplying coupon rate with face value of bonds. As coupon rate and face value are fixed it is also fixed.
Let’s be clear from this example, suppose you bought 10%, 5-years bond of AMC CORPORATION at a par value of $1000. As a bond holder you will receive coupon amount/interest of $100 (10% of $1000) annually for next 5 years.
4. Yield to Maturity (YTM)
Yield to maturity refers to the approximate rate of return that the bond holders earn by holding bonds until maturity. In other word, YTM is a discounting rate that makes the present value of payments received from the bonds equal to it’s price. It can be calculated by using the following formula:
YTH = [I + (M – Po)/n]/[(2M + P)/3]
Or
YTH = [I + (M – Po)/n]/[(M + P)/2]
5. Call price and call period
Some bonds are callable in nature which can be called whenever the the issuer of bond wants or on the specified call period. Call price is the price (per bond) paid by the company to the bond holder when the bond is returned before the maturity period. Call period is the time period at which the bond is called for return.
6. Maturity Period
It refers to the period at the last of which the amount invested on bond is returned back to the bondholders in case of redeemable bonds. Lets be clear from this example, ABC company issues 10%, 5-years bond at the par value of $1000.
In this example, 5 years is the maturity period of bond and the company will returned back the face value to the bond holders at the end of 5 years.
Types of Bonds
1. Corporate and Government Bonds
Corporate Bonds
Every business organization irrespective of their size need fund. They need fund for various purpose such as to expand the business, to develop the new products, to promote the business, installing new manufacturer plants and so on. To collect the required amount of funds the business firm issue debt securities i.e. bonds or debentures. The bonds issued by a company to raise a fund is termed as corporate bond.
Government Bonds
Like a business organization, government also needs money for the development of infrastructures, completion of national or state level projects and for various social and awareness program. So as to collect needed fund, the government issues bond to the public which is known as government bonds. Government bonds are considered as the risk free bonds. There are two types of treasury bonds and municipal bonds.
Treasury bonds are those bonds which are issued by the federal government to manage the needed amount of fund for financing deficit budget or other national level projects.
Municipal bonds are those bonds which are issued by state or local government to finance the state level projects.
2. Redeemable and Irredeemable Bonds
Redeemable Bonds
Redeemable bonds are those bonds which are returned back after few years. Redeemable bonds have certain maturity period on which the bonds are redeemed and bond holders get their investment back. Let’s see this example, Suppose you bought a 5%, 10-years bond of ABC Company at par value of $1000.
In this example, the bond has fixed maturity period of 10 years. It means that you will receive regular coupon payment of $50 annually for 10 years and at the end of maturity you will get back your investment of $1000. This is a redeemable bond as it has certain maturity period.
Irredeemable Bonds
The bonds having uncertain or no maturity period are called irredeemable bonds. Sometimes the company issues bonds which do not have maturity period. By purchasing this type of bonds you will get fixed coupon amount quarterly, semiannually or annually until the company run but you will not get back your invested amount.
For example, suppose you have invested $10000 on bond yielding 10% coupon interest annually.
In this example, no maturity period is given it means that the amount that you have invested will not be returned back. You will only receive the annual coupon payment of $1000 until the company exist and run.
3. Zero Coupon Bonds
The bonds which do not have coupon rate are called zero coupon bonds. Sometimes company issues bonds which doesn’t pay any coupon interest. This type of bonds are issued at huge discount. The investors earn from the gap between face value and the issued price.
Let’s see a example, You purchased a 5-years zero coupon bond at a discount price of $500. It has a face value of $1000.
In this example there is no coupon rate so you will not receive annual coupon payment. At the end of 5th years you will receive a payment of $1000. By purchasing this bond you will make $500 ($1000 – $500)in five years.
4. Callable Bonds
Callable bonds are those bonds which can be returned back by the company before the maturity period if the company wants. The bonds having callable features provide the right to the company to return back bonds whenever it wants or on call period specified in the bond. The company prefer to return the bond before maturity if the market rate is lower than the coupon rate it has provided on its bond.