Bond is a financial instrument whereby the issuer of the bond raises (borrows) capital or funds at a certain cost for certain time period and pays back the principal amount on maturity of the bond. Interest paid on bonds is usually referred to as coupon. In simple words, a bond is a loan taken at a certain rate of interest for a definite time period and repaid on maturity.
From a company’s point of view, the bond or debenture falls under the liabilities section of the balance sheet under the heading of Debt. A bond is similar to the loan in many aspects however it differs mainly with respect to its tradability. A bond is usually tradable and can change many hands before it matures; while a loan usually is not traded or transferred freely.
Table of Contents
- 1 Features of a Bond
- 2 DIFFERENT TYPES OF BONDS
- 2.1 Plain Vanilla Bonds
- 2.2 Zero Coupon Bonds
- 2.3 Deferred Coupon Bonds
- 2.4 Step-Up Bonds
- 2.5 Step Down Bonds
- 2.6 Floating Rate Bonds
- 2.7 Inverse Floaters
- 2.8 Participatory Bonds
- 2.9 Income Bonds
- 2.10 Payment in Kind Bonds
- 2.11 Extendable Bonds
- 2.12 Extendable Reset Bonds
- 2.13 Perpetual Bonds
- 2.14 Convertible Bonds
- 2.15 Foreign currency convertible Bonds
- 2.16 Exchangeable Bonds
- 2.17 Callable Bonds
- 2.18 Puttable Bonds
- 2.19 Treasury Strips
- 2.20 Yankee Bonds
- 2.21 Samurai Bonds
- 3 Bond Valuation
Features of a Bond
Let us have a look at the common features of bonds and the financial terms related to bonds.
The entities that borrow money by issuing bonds are called as issuers. In the US, there are mainly 4 major issuers of bonds which include the government, government agencies, municipal bodies, and corporates.
Every bond that is issued has a face value; which is usually the principal amount that is borrowed and returned on maturity. In layman’s term, it is the value of the bond on its maturity.
The rate of interest paid on the bond is called as a coupon.
Every bond is usually rated by credit rating agencies; higher the credit rating lower will be the coupon required to pay by the issuer and vice versa.
Coupon Payment Frequency
The coupon payments on the bond usually have a payment frequency. The coupons are usually paid annually or semi-annually; however, they may be paid quarterly or monthly as well.
The effective return that the investor makes on the bond is called as a return. Assuming a bond was issued for a face value of $ 1000 and a coupon rate of 10% on initiation. The Price at a later date may rise or fall and hence the investor who invests at a rate other than $ 1000 will still receive a coupon payment of $100 (1000 * 10%) but the effective earning shall be different since investment amount is not $1000. That effective return in layman’s term is called as the yield. If the holding period is considered for a year this is referred to as current yield and if it is held to maturity it is referred to as yield to maturity (YTM).
There are many types of bonds issued that differentiate each other in respect of their features. These features vary depending upon the requirement of the issuer. Let us have a look at some of the major types of bonds issued.
DIFFERENT TYPES OF BONDS
Plain Vanilla Bonds
A plain vanilla bond is a bond without any unusual features; it is one of the simplest forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond.
Zero Coupon Bonds
A zero coupon bond is a type of bond where there are no coupon payments made. It is not that there is no yield; the zero coupon bonds are issued at a price lower than the face value (say 950$) and then pay the face value on maturity ($1000). The difference will be the yield for the investor. These are also called as discount bonds or deep discount bonds if they are for longer tenor.
Deferred Coupon Bonds
This type of bond is a blend of a coupon-bearing bond and a zero coupon bond. These bonds do not pay any coupon in the initial years and thereafter pay a higher coupon to compensate for no coupon in the initial years. Such bonds are issued by corporates whose business model has a gestation period before the actual revenues start. Examples of a company which may issue such type of bonds include construction companies.
These are bonds where the coupon usually steps up after a certain period. They may also be designed to step up not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to grow in a phased manner. These are also called as a dual coupon or multiple coupon bonds.
Step Down Bonds
These are just the opposite of Step-Up Bonds. These are bonds where the coupon usually steps down after a certain period. They may also be designed to step down not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing.
Floating Rate Bonds
Floating rate bonds are so called because they have a coupon which is not fixed but rather linked to a benchmark. For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps (100 bps = 1%), In such cases on every interest payment date, the payment will be made 0.50% more than the treasury bill rate prevailing on the fixing date.
These types of bonds are similar to the floating rate bond in that the coupon is not fixed and is linked to a benchmark; however, the differentiating thing is that the rate is inversely related to the benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes down and vice versa.
A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon cash flow may increase if the profit/ income levels of the company rise to a pre-specified level and may reduce when income falls below a pre-specified level; thereby the investor participates in the return enjoyed based on company revenues/ income.
Income bonds are similar to participatory bonds however these type of bonds do not have a reduction in interest payments if income/ revenue reduces.
Payment in Kind Bonds
These types of bonds pay interest/coupon, not in terms of cash payouts but in the form of additional bonds.
Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity if required. The holder has an additional benefit in this case because if the rate of interest in the market reduces, the holder may choose to extend the tenor and enjoy the higher rate of interest in terms of coupon payment. For this benefit, the holder may enjoy the coupon rates that are usually lower than a plain vanilla bond.
Extendable Reset Bonds
These are types of bonds which allow the issuer and the bondholders to reset the coupon rate based on the then prevailing market scenario. This is not linked to any benchmark but on the basis of renegotiation between the issuer and the bondholders. This is usually the case where bond tenor is very long.
These types of bonds pay a coupon rate on the face value till the life of the company. Though Perpetuity means forever, bonds with maturity above 100 years are also considered to be perpetual bonds.
Foreign currency convertible Bonds
Foreign currency convertible bond is a special type of bond issued in the currency other than the home currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency.
These bonds are similar to the convertible bonds but differ in one aspect that they can be exchanged for equity shares but not of the issuer. These can be exchanged for equity shares of another company which the issuer may have stakeholding.
Bonds that are issued with a specific feature where the issuer has the right to call back the bonds at a pre-agreed price and a pre-fixed date are called as callable bonds. Since these bonds allow a benefit to the issuer to repay off the liability before maturity, these bonds usually offer a coupon rate higher than a normal straight coupon-bearing bond.
Bonds that are issued with a specific feature where the bondholder has the right to return back the bonds at a pre-fixed date before maturity are called as puttable bonds. Since these bonds allow a benefit to the bondholders to ask for the principal repayment before maturity, these bonds usually offer a coupon rate lower than a normal straight coupon-bearing bond.
In the US, Government dealer firms usually break down a coupon-bearing bond into a series of zero coupon bonds by considering each cash flow as a separate bond. For example, a 5-year semiannual coupon-bearing bond can be split into 10 zero coupon bonds with coupon amount as face value and 1 zero coupon bond with principal amount as the face value. The bond stripping usually is done to increase liquidity and facilitate easy tradability.
A dollar-denominated bond issued in the US by an issuer who is outside the US is called as Yankee bond.
A yen-denominated bond issued in Japan by an issuer who is outside Japan is called as Samurai bond.
Shogun Bonds: A non-Yen denominated bond issued in Japan by an issuer who is outside Japan is called as Shogun bond.
Valuation of bond can be easily done using present value technique. First, we need to understand the cash flow pattern of the bond. Secondly, the appropriate discounting factor should be decided. Lastly, discount the cash flows found in the first step using the discount rate found in the second step.
Cash Flow from a Bond
Before moving forward towards valuation, let us understand a bond terminology and their cash flow patterns etc in little details. If a bond is paying 6% interest rate having the face value of $1000 and maturity of 5 years. It means that it will pay $60 every year till its maturity and repay $1000 at the end of 5th year. Cash flow table will be like the below:
Cash Flows ($):
Year1 Year2 Year3 Year4 Year5
$60 $60 $60 $60 $1060
Determining the Appropriate Discounting Rate
For valuing the above bond using present value technique, it is utmost important to find the most appropriate discounting rate. For example, let’s consider the above bond is issued by a government agency and there is another government agency offering another bond at 5%. Since the bonds are issued by the government agency, they are almost risk-free or at least both of them assume the same level of risk. We can safely use 5% as our discounting rate because you can invest in 5% bond if you do not invest in the 6% bond and therefore the interest of 5% bond is your opportunity cost.
Find Present Value of the Cash Flows i.e. Market Value of Bond
Once we have determined the most appropriate discounting rate for our situation, rest of the steps of valuation are very easy. We will now find the present value of the future cash flows or the discount the cash flows based on the discounting rate and add all of them. The result will give you the valuation of 6% bond i.e. the intrinsic value of the bond which can be construed as an ideal market price of the bond.
Intrinsic Value of Bond =
Intrinsic Value of Bond = $1043.295.
The value of bond under the given conditions is $1043.295. It can be interpreted from the calculations that the intrinsic value is more than its purchase price of $1000. At the time of issuing the bond, an investor can get this price but once the bond opens for open market trading, the price will adjust according to the market conditions. If a bond is to be purchased from the open market, the same analysis can be done to find out the approximate value of the bond and take an informed decision.
Using Annuity for Valuing Longer Term Bonds
One practical problem in the calculation will appear if the bond is of say 20 years. An annuity is a solution for that. We will break the cash flows into two – the coupon payments and the principal repayment. We will find the present value of coupon payments using the annuity method and principal will be discounted using the normal method. Let’s use this method for the above calculations:
Present Value (PV) of Bond = PV (Coupon Rate) + PV (Principal)
= Coupon Amt. * 5 Yr. Annuity Factor + Principal * Discount Rate
= 60 * 4.3295 + 1000 * 0.7835