How Do Bonds Work

How Do Bonds Work

Bonds are a commonly traded form of fixed income securities. Here, we try to understand the concept of bonds and how they work.
A bond is essentially a loan that an investor gives to a body corporate or a governing body, and in return, is paid an interest. Thus, the phrase 'purchasing a bond', actually means 'giving a loan'. The entity which originates the bond is known as an issuer, and a person who purchases it is known as the owner. In the primary market, bonds are issued by corporations or governments through underwriters, financial companies, investment banks or brokers. The Central Bank, of a particular nation, usually issues bonds on behalf of the government. Bonds can be issued at three types of prices, namely, 'at par', 'at discount', and 'at premium'. When a bond is issued at its face value, it is termed as 'issue at par'. 'At discount' means an issue at lower than the par value and 'at premium' is greater than the par value.

Maturation

The time period of a bond begins on date of issue and ends on the maturity date. During this time period, the interest is paid to the owner on a monthly or yearly basis. In some cases, interest is accumulated and then paid to the owner on date of maturity. For most issues, rate of interest is fixed, but in case of a floating rate bond, the rate of interest is decided on the basis of credit markets. On the date of maturity, the ownership automatically expires and the principal amount is remitted to the owner.

Secondary Market Trading

One can also trade bonds in the secondary market at the prevailing market price. Trading price of a bond depends on its credit score and issue price. The credit rating is expressed with the help of an alphanumeric figure. For example, AAA is considered as 'lowest risk'. The credit rating agencies have different formulas to calculate the credit rating. Bonds of a body corporate, that has not financially established itself, is bound to have a low rating. On the other hand, a financially strong corporation would have a very good rating. In the same manner, bonds issued by a stable government will have a higher credit rating as compared to that of a volatile government.

Types of Bonds

Following are some of the common types of bonds:
  • Government Bonds: These are the oldest type of bonds to be issued. They are sometimes issued for a specific purpose, like funding an infrastructure project. Government bonds carry a very high credit rating and are issued at a discounted price in many cases.
  • Municipal Bonds: They are also called 'munis'. These type of bonds are issued by local governing bodies for specific purposes, like building hospitals or providing other civic amenities. They come with a high credit rating and market value. In case of government and municipal bonds, the holders qualify for tax exemption.
  • Corporate Bonds: Issued by corporations, they can be secured or unsecured in nature. Secured bonds are 'tied down' to specific assets of the company. If the company goes into liquidation, such bonds are repaid by liquidating the assets of the company. Unsecured bonds, in case of liquidation, may or may not be repaid, thus they are high risk.
  • Floating Rate Bonds: These bonds do not have a fixed rate of interest. Most of the floating rate bonds have a low credit rating and less market value.
Bonds are a useful asset class that have become popular to generate consistent income, for speculative trading, and as collateral for loans.
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