A bond, put simply, is a loan taken out by companies which is financed by the general public.
It is classified as a fixed income investment, which enables companies to borrow funds for a defined period of time (known as the term to maturity) at a variable or fixed interest rate (known as the coupon rate).
Bonds can either be corporate or governmental, and are commonly used to raise money and finance a variety of developments and activities.
There are numerous advantages for an entity to issue a bond rather than opting for a bank loan. The main reason being that compared to bank loans, bonds offer a better cash liquidity to businesses.
The reason being that bank loan repayments consist of the annual interest expense of the loan and also part redemption of the principal amount loaned, while as in a bond issue, the issuer (being the entity issuing the bond) is only liable to annually pay the coupon to the bondholders and repay the full principal amount on maturity.
The issuer also has the option to pay the coupon on an annual, semi-annual or quarterly basis as best benefits its cash flow requirements. Another advantage of a bond issue is that a bond can be either issued as secured or unsecured as opposed to a loan, which in the majority of cases is covered by a loan hypothecate.
The most important aspects when analysing a bond are the price, the coupon rate and yield, as well as the maturity and redemption features of a bond. The price of a bond is the first consideration and is dictated by the sellers and buyers within a market.
A bond is issued at par value, typically being €100. A bond can trade at premium to par value, meaning that it is trading above its par value or it can trade at a discount to par value, meaning that it is trading below its par value.
Coupon rate (interest paid on the bonds) can either be fixed, variable or only payable at maturity (known also as zero-coupon bond). Irrespective of the bond price the coupon rate will always be calculated on the par value of the bond.
A bond’s yield is closely related to the interest rate, it is defined as the return earned based on the price paid for the bond and the interest received.
There are two types of yield being the current yield and the yield to maturity.
The current yield is the annual return on the total amount paid for the bond. Thus it is the effective interest rate an investor will get when purchasing a bond. The yield to maturity is the total return one will receive by holding the bond to maturity.
The maturity of a bond represents the date on which the principal amount borrowed by the issuer is repaid back to bondholders. The maturity can range anywhere from one to thirty years.
Some bonds allow the issuer to redeem the bond prior to maturity, such bonds are called a callable bond. Conversely, a noncallable bond cannot be redeemed prior to maturity.
The above is only an introduction to bonds and does not delve into the advanced concepts and the risks associated with investing in bonds.
This article was issued by Rowen Bonello, research analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.