What is a bond?
A bond is a written undertaking on the part of the borrower to meet the terms of the loan, i.e., to pay the principal and interest amounts on the stipulated dates. On the stock exchange, the word “debt” is usually used instead of “loan”. To make the explanation easier to understand, both “debt” and “loan” will be used in turn.
The Function of the Stock Exchange
The stock exchange is a market where securities are bought and sold (i.e., traded). A security is a document that is worth more than the paper on which it is printed. Only certain types of securities are traded on the stock exchange. The main types of securities traded on the stock exchange are stocks, bonds, and options.
The stock exchange includes both the primary market, which means the initial sale of a security by the issuer (i.e., a company or the government) to the public at large; and the secondary market, which means the sale of a security by an investor from the general public to another investor with no connection to the issuer.
Without the mechanism of the stock exchange, companies would be unable to raise loans from the general public. The only way they would be able to raise money would be through banks.
The stock exchange enables companies to raise money from the public, and facilitates trading in bonds between investors. To learn more about the stock exchange visit our course on “Fundamentals of the Stock Market”. Just as a bank grants a loan to its customers, the public can grant a loan to a company. Like a bank, the investors expect to receive a suitable fee for the money that they lend to the company, i.e., they expect to receive interest from the company. These user’s fees are affected by the duration of the loan to the company, and by the investor’s evaluation of the risks incurred while granting a loan to the company. In other words, the investor evaluates the probability that the loan will be repaid. The investor usually expects to receive a higher rate of interest than would be available by depositing the money into a bank.
Example
A company wishes to borrow $1 million from the public for two years. It is agreed that the company will pay 10% interest per annum. The company prepares in advance 1,000 bonds with a face value of $1,000 each (i.e., the bonds are usually denominated in face values of $1,000). Each lender from the public receives one bond with a face value of $1,000 from the company for each $1,000 that is loaned. In many cases, the company grants the public a discount, i.e., the public pays only $950, $900, or some other discounted sum for the bond. At the end of two years, the company redeems each bond for $1,000, even if the investor paid $900 for it. If investor A loaned the company $10,000 for two years (meaning that he bought bonds worth $10,000), then he will receive from the company 10 bonds of $1,000 face value each.
For each bond with a $1,000 face value, the company will pay the investor the following sums over two years:
Table 1.4: Calculating Repayments for a Bond with a $1,000 Face Value
The principal is usually repaid at the end of the period, and in this case at the end of the second year. Bondholders are entitled to sell their bonds to anybody else at any time. The company is obligated to pay the interest and to repay the principal on the dates stipulated by the bond to the party holding the bond at that time, whether the party is the first, second, or fifth owner.
|
|
Principal (in $) |
Interest (in $) |
Total (in $) |
|
At the end of the first year |
|
$100 (10%) |
$100 |
|
At the end of the second year |
$1,000 |
$100 (10%) |
$1,100 |
|
Total over two years |
$1,000 |
$200 |
$1,200 |
Buying Bonds
When an investor receives a bond for the money that has been loaned to a company, then this action is called “buying a bond” although they are actually extending a loan. A bond is an asset held by an investor, which can be sold at any time on the stock exchange in the same way that shares are traded.
Any transaction where bonds are transferred from one investor to another is referred to as “buying bonds” and “selling bonds”.
The Terms of a Bond
Five main figures stating the terms of the loan are printed on the bond. They are as follows:
-
Face value (FV) – the amount of the principal that must be repaid.
-
Maturity date – the date when the principal payment is due to be repaid to the investor.
-
Coupon rate – the annual rate of interest paid, which is always given as a percentage of the face value.
-
Interest payments dates.
- Guarantees – this item states whether the company has provided any guarantees for assuring payment of the interest and the principal. Real estate, inventory, and bank deposits are all commonly used as guarantees.
Whether Buying Bonds is Worthwhile
The decision by a public investor to buy a bond (in other words, to grant the issuing company a loan) depends on the terms of the bond, i.e., the amount that will have to be paid now as compared with the interest received when the bond is redeemed, plus the sum at maturity.
For example, if Walmart issues bonds with a face value of $1,000 that mature in one year, and they offer a coupon rate of 20%, then there will be a very large number of buyers willing to pay more than $1,000 for such a bond since they will receive $1,200 at the end of the year, which is far more than any available market alternative (note: 20% annual interest is considered extremely high and exceptional in the money market, so there will be quite a few investors willing to buy Walmart’s bonds at this coupon rate).
However, if Walmart is paying a 2% coupon rate, it will almost certainly find no one willing to pay $1,000 for its bonds. At $900, on the other hand, it will probably find some U.S buyers, since a buyer is due to receive $1,020 at the end of the year (i.e, $1,000 in face value, plus $20 in interest). This represents in effect a profit of more than 13% per year bearing in mind that the bond was purchased for $900.
In the primary market (i.e., the stage when the company issues the bonds), the bond price is essentially determined by supply which is determined by the quantity of bonds offered in the issue) and demand. In the secondary market where investors trade bonds between themselves without any intervention from the company, supply is determined by the quantity of bonds offered for sale at any given time.
