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Bond is a debt security issued by the government/corporation or any other entity to raise funds. It is a contract to repay borrowed money with interest at fixed dates (it is like a loan where the issuer is the borrower and the holder is the lender).
| Bonds | Stocks |
|---|---|
| Debt instruments | Equity instruments |
| By purchase of bond an investor becomes a creditor/lender to the corporation | By purchase of equity an investor becomes an owner in the corporation |
| In case of bankruptcy, bondholder gets paids before the stakeholder | In case of bankruptcy, shareholder gets paids after the bondholder |
| Bondholder has no voting rights | Shareholder has no voting rights |
| Bondholder receives the coupon payments but no dividend payments | Shareholder receives the dividend payments but no coupon payments |
| Coupon payment is an obligation | Dividend payment is non-obligatory |
| Bonds Issuer | Bond investor |
|---|---|
| Domestic and international markets accessibility | Gets access to the credit risk of the issuer as per the bond rating |
| Capital is raised without parting with the ownership of the organisation | Enable diversification to investment portfolio |
| Liquidity through access to a secondary market | |
| Periodic returns on the investment, subjects to the credit risk of the issuer | |
| Opportunity to trade in the bonds for sophisticated investors |
There are multiple types of Bonds which are differentiated by their varying payment features
The term Fixed Rate Bond is an interest-bearing deposit made for a fixed length of time that provides the depositor with little or no access to their funds, similar to a Certificate of Deposit (CD). In other countries, a Fixed Rate Bond is a security issued by a government or business corporation which pays out a fixed interest rate on the amount of the face value of the security. Such Fixed Rate Bonds are long term securities.
Floating Rate Bond is a bond whose interest amount fluctuates with the market interest rates or some other external measure. Price of Floating Rate Bonds remain relatively stable because neither a capital gain nor a capital loss occurs as market interest rates go up or down.
Subordinate Bond is a bond that, in the event of liquidation, is prioritised lower than other types of bonds. For example, a subordinate bond may be an unsecured bond, which has no collateral. Should the issuer be liquidated, all secured bonds and similar debts must be repaid before the subordinated bond is repaid. A subordinate bond is high in risk but also pays higher returns than other bonds.
A bond that can be converted into a predetermined amount of the company’s equity at certain times during its life, usually at the discretion of the bondholder. These are also referred to as CVs.
A debt security that doesn’t pay interest (a coupon) but is traded at a deep discount, giving profit at maturity when the bond is redeemed for its full face value.
A bond investor takes credit risk on the issuer.
| Credit Risk | Is the issuer risk - i.e., the risk that the issuer may default on the principle or coupon payments. A bond is not a fixed deposit. The price and yield of a bond is heavily linked to intrest rates |
|---|---|
| Price Risk | > A downgrade in the rating of a bond will adversely affect the price of the bond |
| Reinvesment Risk | Intermediate coupons will have to be invested at prevailing intrest rates |
| Market Risk | Higher than the purchase for the bondholder. |
Upon investing in a bond, you can choose to hold on to it till its maturity. At the end of the term, you will recover the principal repayment and receive the scheduled coupon payments in the intervening period.
Before its maturity date, you can also sell the bond in the open secondary bond market as the bondholder. In the market, you can monitor bond prices and trade them in an attempt to accrue capital gains.
When interest rates rise, bond prices fall and vice versa.
When new bonds are issued, they carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an ‘inverse relationship’ - when one goes up, the other goes down. To understand how the prevailing market interest rate impact the value of a bond one needs to understand the concept of ‘opportunity cost’.
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond’s coupon rate - which is fixed - becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.
Suppose Company X offers a new issue of bonds carrying a 7% coupon. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value, AED 1,000. This means it would pay you AED 70 a year in interest.
Now let’s suppose that later that year, interest rates in general go up. If new bonds from Company Y costing AED 1,000 are paying an 8% coupon (AED 80 a year in interest), buyers will be reluctant to pay you face value (AED 1,000) for your 7% X bond. In order to sell, you’d have to offer your bond at a lower price - a discount - that would enable it to generate approximately 8% to the new owner.
Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than AED 1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.