When one hears the word bond the first thing which comes into mind is the movie franchise of James bond, however in finance it is not about guns, new gadgets and cars but it is about face value, interest, yield and such terms. In finance bond refers to a debt instrument which has legal implications, a bond holder has the right to receive periodic interest and repayment of the principal at the time of maturity from the issuer. Bonds are usually expressed in yields which denote the interest that a bond pays and it is expressed as a percentage face value of the bond. A bondholder gets fixed income in the form of periodic interest and that is the reason they are categorized as fixed income investment. There are different types of bonds which are transacted in the markets, let’s look at some of them –
Types of Bonds
They are also known as treasury bonds, these are issued by the government of the country and hence they are considered to among safest investment because if government is not able to pay you interest and principal amount back then who will and that is the reason why investors lap up bonds issued by government if they offer attractive rate of interest. They are of different maturities such as 90 days, 180 days, 1 year, 10 year and so on.
Many investors also buy these in order to do tax planning and liquidity management as such investments are tax free up to certain limit and also they are very liquid as they can be bought and sold whenever you want because the depth of the market is very good when it comes to government paper.
It is similar to normal bond, however it has one additional feature which is that after certain point of time an investor can covert his or her bonds into equity shares of a company. The rate of interest on these types of bonds is lower than normal bonds because they offer scope for capital appreciation in the form of common stock. The price of these bonds depend upon the price of equity stock which is trading in the stock market so if the price of stock is higher than in the bond market the convertible bond would also trade higher and vice versa.
For example if a bond gives an option to convert into 2 equity share for every 1 bond and value of bond is $100, now suppose the price of stock is $60 then an investor would be getting $120 by exercising his or her option and he or she would be making good return. Now consider the opposite case where the stock price is low and it trades at $45 dollar per share only than an investor would be making only $90 thus making loss. Companies which are listed in stock exchanges and also do not want to pay higher rate of interest go for such issuing in order to attract investors.
These types of bonds are issued by private companies in order to raise funds from the general public. They are different from treasuries in the sense that the risk of default is far greater and that is the reason why the rates of interest offered by such bonds are higher than government bonds. Apart from default other risks also exist like liquidity risk, which implies that an investor may not be able to get out of this investment when he or she needs the money because of lack of depth of such bonds.
Companies which are of good reputation and have higher credit worthiness can raise good amount of money at lower cost (since they offer lower rate of interest due to less risk) through this method. For example a company like Apple would be giving lower interest to bondholders than other companies because of strong balance sheet and cash flow of Apple and hence lower risk of default.
Zero Coupon Bonds
Zero Coupon Bonds are those bonds which are purchased at price lower than face value and at the time of maturity an investor would get face value of the bond held by him or her. In this type of an investment the investor won’t get any periodic interest rather he or she is getting deep discount at the time of initial purchase and therefore they are different from normal bonds instruments.
They are high yield bonds which are issued by companies facing financial crisis and therefore they are compelled to pay higher rates of interest to investors investing in their issue. Investors who have high risk appetite usually invest or trade in such bonds in order to make quick returns from such investment.
It refers to those bonds which are issued in different currency from the currency of the country in which it is issued. So for example if a European country issue bonds in china in dollars it will be called Eurobond.
Inflation Linked Bonds
As the name suggests these types of bonds are issued in order to hedge against the risk of inflation. The periodic interest payment is given to investor according to predefined formula which takes into account the inflation factor. So suppose the inflation rises from 5 % to 6 % than interest payment will also rise accordingly hence compensating the investor for the rise in inflation. They are also known as Inflation indexed bonds, however such type of bonds are not that widespread.
Foreign Currency convertible Bond
Foreign currency convertible bond also known as FCCB refers to that bond which is issued by the company in a currency which is different from home country currency. So for example an Indian company issuing dollar denominated bonds would constitute as FCCB. Companies issue such bonds in order to take advantage of currency fluctuation which in turn reduces their total cost of borrowing and for investors this is beneficial because they get option to convert their bonds into equity.However companies should exercise caution while issuing FCCB because if currency does not behave as anticipated by the issuer than it can lead to huge foreign exchange loss and can jeopardize the financial condition of the company at the time of repayment of principal.
As one can there are many types and variation in the type of bond which are issued by the company and with growing complexities in the financial market and competition among firms to lure investors towards them they keep improvising by adding new features to their issue and this process would keep going until there is the need for money by companies which we all know is everlasting.