Bonds definition and their importance in the economy
Bonds play a vital role in the global economy and the national economy, affecting finance and investment and providing realized opportunities for investors, government entities, and companies. The types of bonds vary and differ in such things as maturity, interest, payment recipe, and other conditions. The following will clarify the difference between the types of bonds and how they operate.
Bonds are one of the primary financial instruments used in financial markets. Bonds are a financial tool companies and governments used to raise funds from investors. The purchase of bonds is a guaranteed and profitable investment. The issuer undertakes to pay a certain amount of money to the holder on the maturity date as well as paying a fixed amount according to a fixed percentage as a regular interest during the underwriting period as dividends to the bond purchase amount.
Bonds can be defined as documents used to raise funds from investors by selling them as bonds, governments and companies often issue bonds to finance their projects, expand their operations, close budget deficits, or develop infrastructure.
When investors purchase bonds, they lend the company or the issuing government an amount of money for interest determined on the basis invested until the original amount is paid.
Bonds’ legal definition
The bond is a financial obligation issued by the company or the government for the purpose of raising funds, in which the issuer undertakes to pay a certain amount of money to the holder on the maturity date, in addition to paying regular interest during the subscription period.
The bonds are classified into several types according to the issuer, the maturity period and the interest type as follows:
First: According to the issuer:
Issued by governments to finance budget deficits, implement public projects, or finance their activities. Such bonds are considered to be the lowest risk and have a high level of confidence.
Issued by companies to finance their business activities or create investment opportunities, but such type carries a higher level of risk and has higher returns than government bonds.
Second: According to the maturity period:
- Short-term bonds: Less than one year’s duration.
- Medium-term bonds: Ranging from one to five years’ duration.
- Long-term bonds: More than five years’ duration.
Third: According to the type of interest:
Fixed Interest Bonds:
Bonds that calculate the same interest rate throughout the subscription period unchanged.
Floating rate Bonds:
Bonds whose interest rates change according to the change of the market interest rate, when the interest rate rises the bond rate falls, and vice versa.
Fourth: Secured bonds:
These bonds are used to attract investors looking for a lower-risk investment as companies issue this type of bond with the guarantee of another company such as insurance companies.
Fifth: Convertible bonds:
The bondholder is entitled to convert them into shares in the issuer company at a specified time, and these bonds are an attractive option for investors who wish to participate in the company’s potential growth.
Maturity date and bond term:
The bond shall specify both its maturity date and its term, and there is a difference between them.
1- Maturity date
The maturity date of a bond or the time to maturity of a bond is the period of time until the final payment of the bond is made, and it expires – the active lifetime of the bond.
2- Characteristics of the bond
The term of a bond determines two characteristics of the bond:
- “Macaulay duration” is the amount of time it takes for the bond to pay back the original loan amount, and is expressed in years.
- Modified duration is a measure of the sensitivity of the bond price to changes in interest rates, and the longer the bond’s maturity, the more volatile its price will be with changes in interest rates.
Credit rating agencies assess the creditworthiness of bond issuers, giving market participants a deep and valuable view and giving them a good opportunity to assess the credit risks of bonds, which is critical for both issuers and potential buyers.
The lower the credit risk of issuers – or the higher their valuation – the lower the coupon prices, which reduces the cost of borrowing. Conversely, the higher the credit risk of an issuer, the more there is a need to increase its yields to attract investors.
Investors need to know if an issuer is well-placed to repay the loan principal and pay coupons regularly and on time. Similarly, issuers can use ratings to price their bonds at a level that attracts investors.
To use an agency scale “for example”, less risky long-term bonds are assigned an AAA rating, while the rating of weak investments or junk bonds starts from BB+.
Bonds face value (nominal) and the issue price:
Bonds face value is the amount of the principal loan that is agreed to be paid to the bondholder, excluding coupons. In general, this amount is paid as a single lump sum payment at the maturity of the bond or its expiration and remains unchanged throughout the bond’s lifetime.
However, this is not always the case. For example, some index-linked bonds – such as Treasury Inflation-Protected Securities (TIPS) – adjust the face value in line with inflation.
Theoretically, except zero bonds, the issue price should be equal to the bond’s face value. This is because the mock value is equal to the full value of the loan, which is paid to the issuer upon purchase of the bond. However, the price of a bond on the secondary market – after it has been issued – can fluctuate substantially depending on a variety of factors.
Zero bonds make no coupon payments, which means that in order to pay interest, the issue price is below the bond’s face value.
Coupon rates and dates:
The coupon price of a bond is the relation between the value of the bond’s coupon payments and its face value, expressed as a percentage. For example, if the face value of a bond is 1000 pounds, and it pays an annual coupon of 50 pounds, then the bond’s coupon rate is 5% annually.
Coupon rates are typically calculated on an annual basis, so two payments of 25 pounds would also return a coupon rate of 5%.
It is important to distinguish between a bond’s coupon rate, current yield, and yield to maturity.
- Current yield is the interest earned on the bond’s current market price via its annual coupon payments.
- Yield to maturity is a more complex calculation that expresses the total interest earned on the bond’s current market price over the remaining period of its lifespan, including all future coupon payments and the original loan amount.
Coupon dates are the dates on which the bond issuer is required to pay the coupon, The bond will set these dates, but of course, coupons are paid annually, semi-annually, or monthly.
Bond prices can be determined to include or without a coupon and when the bond price is not inclusive of the coupon, the price does not include the next coupon payment, and when the bond price is inclusive of the coupon, the price includes the next payment.
Definition and types of Bonds in the Egyptian Exchange
A bond is a debt instrument, used by companies as a means of borrowing. The lender is called the buyer of the bond and the borrower is called the seller or issuer of the bond.
The issuer of the bond undertakes to pay the bondholder a pre-defined interest or coupon during the life of the bond and to reimburse the face or par value of the bond at the maturity date.
Bond’s available types in the Egyptian Exchange:
Government bonds are bonds issued by the government for public expenditure. There are three types of bonds traded on EGX: treasury bonds (Primary dealers’ system) – Housing Bonds – and Development Bonds.
Corporate Bonds are issued by corporations to finance business expansions and development. There are three types of bonds traded on EGX, namely fixed-rate bonds – floating-rate bonds – securitized bonds.
Causes affecting bond prices
Supply and demand:
- Just like any tradable asset, bond prices are subject to the supply and demand forces.
- The supply of bonds is dependent on issuing organizations and their need for funds.
- Demand is determined by a bond’s attractiveness as an investment – compared to alternative opportunities.
- Interest rates play a decisive role in determining supply and demand.
How close the bond is to maturity:
Newly-issued bonds will always be priced with current interest rates in mind, meaning that they’ll usually trade at or near their par or face value. And by the time a bond has reached maturity, it’s just a payout of the original loan – meaning that a bond will move back towards its face value as it nears this phase.
The number of interest rate payments remaining before a bond matures will also have an impact on its price.
Although bonds may often be seen as conservative investment instruments, distress situations remain likely, and riskier bonds are usually traded at a lower price than lower-risk bonds at a similar interest rate.
As mentioned, the main method of assessing the risk of a bond issuer’s faltering is through its rating by main credit rating agencies.
High inflation is usually bad news for bondholders. This can be attributed to two factors:
- A bond’s fixed coupon payment amount becomes less valuable to investors when money loses its purchasing power.
- Central monetary authorities often react to high inflation by raising interest rates, as interest rates and bond prices are inversely related, the higher interest rates result in a lower market price for the bond.
Risks of the bonds
Credit risk is the risk that the bond issuer will not be in a position to make coupon or principal repayments in full and on time. in the worst cases, the debtor could default completely.
Rating agencies evaluate creditworthiness and rank issuers accordingly.
Interest rate risks:
Interest rate risk is the potential that rising interest rates will cause the value of your bond to fall, due to the impact of higher interest rates on the opportunity cost of holding a bond when you could get a better return elsewhere.
Inflation risk refers to the possibility that rising inflation will cause the value of your bond to fall. If the rate of inflation rises over the coupon rate of your bond, then your investment will actually lose money.
Index-linked bonds can help mitigate this risk.
Liquidity risk is the chance that a market may not have enough buyers to purchase available bonds quickly, and at the current price, If the bond issuer needs to sell rapidly, he may need to drop his price.
Currency risk only applies if only when purchasing a bond in a different currency from the investor’s reference currency, and exchange rate fluctuations may result depreciation of the investment in general.
Bond recall risks:
Recall risk occurs when the bond issuer has a right, but not the obligation, to repay the face value of the bond before its official expiry date. The absence of the remaining coupon payments could result in a loss of fixed income, or possibly a lower yield to maturity on the investment.
Finally, bonds are an important financial tool in the economy and play a main role in financing companies and governments and promoting economic growth. Bonds also provide an opportunity for investors to diversify their investments and generate regular returns. However, investors shall be aware of the risks linked to bonds and evaluate their quality before making an investment decision.