The mechanics of bonds
All bonds have a face value (or par value), an interest rate (coupon rate) paid on the bond by the borrower, and a maturity date. Let us examine each of these elements in more detail.
A company issues bond certificates with a single face value (FV), which is the value that appears on the certificate. This is usually equal to £100 or £1000, while the total value of the bonds issued at a certain time could be millions (or even billions) of pounds. For convenience, bonds are often referred to in units of 100, though investors can buy smaller or larger sums and part-units.
The market value of the bonds is the price at which the bond market, that is where issued bonds are traded, is selling or buying the bond. When the market value (MV) is higher than the FV, it is said that the bond is trading at ‘premium’; by way of contrast, when the MV is lower than the FV, it is said that the bond is trading at ‘discount’. Finally, if the MV and FV are equal, the bond is trading at ‘par’.
Table 8 Bond trading prices
|Face value (FV)||Market value (MV)||The bond is trading at|
|£100||£101||A premium to par|
|£100||£99||A discount to par|
The positive or negative difference between MV and FV value is given by the fact that the bond is traded, hence the fluctuations in buying and selling are reflected in its value.
In a primary offering, an investor buys the bond for par value from the issuer. The issuer pays interest to the investor periodically (usually annually), which is calculated by multiplying the face value by the coupon rate. For example, a bond with a fixed coupon issued at a face value of £100 with a 5% annual coupon rate will pay a coupon of £5 (i.e. £100 × 0.05) each year, or two semi-annual coupons worth £2.50 each. When the bond matures, then the bondholder will get back the par value of the bond.
A bond typically has a maturity date on which the bond expires, and the principal is paid back to the investors. For example, a 10-year corporate bond issued in June 2019 will mature in June 2029. Bonds typically have maturities in the range of 1 to 30 years. Undated or perpetual bonds, with no defined maturity date, can also be issued, although such issues are infrequent. The bulk of funding activity in the bond market is in maturities of up to 10 years.
If bondholders decide to hold a bond until the maturity date, then they can expect to receive a return commonly referred to as ‘yield to maturity’ (YTM), which equals the total interest payments to the investor plus any gain (or loss) between the price the bond was purchased at and the repayment price. For the purpose of this course you do not need to know how to calculate the YTM, you just need to note that a bond’s YTM considers its face value, purchase price, coupon rate, duration and compound interest.
Common types of bonds
Along with fixed coupon bonds, referred to in the previous example, there are other types of bonds which pay interest rates differently. Table 9 describes the most common types of bonds.
Table 9 Common types of bonds
|Fixed coupon bonds||Fixed coupon bonds are long-term debt instruments paying a fixed coupon rate until maturity. Investors are certain about the amount and quantity of coupons they will receive.|
|Floating rate (or variable) bonds||With floating rate (or variable) bonds the coupon is re-fixed periodically, typically each quarter (or each month, or half year). These bonds typically have a variable coupon that is indexed to a benchmark interest rate, such as the LIBOR (London Inter-bank Offered Rate) for example.|
|Zero coupon bonds||
Zero coupon bonds pay no interest and pay only principal value at maturity. They are usually issued at a price which is significantly below the par value and redeemed at par on maturity. Zero coupon bonds are very common and are issued by companies, as well as by states and local governments.
|Convertible bonds||A convertible bond gives investors the right to convert their bond into a predetermined number of ordinary shares or sometimes cash. The right to exercise the option to convert can be continuous throughout the life of the bond or can be applied only on defined dates.|
Activity 8 The basics of bonds
Now you have gone through the main components of bonds, work through the following activity and match the definition with the corresponding key term.
Using the following two lists, match each numbered item with the correct letter.
Zero coupon bond
Floating rate bond
a.The price at which the bond market is selling or buying the bond
b.The end of the fixed lifetime of a bond, usually between 1 and 30 years
c.Bond in which the coupon is re-fixed (typically quarterly, monthly, or half yearly), with reference to a fixed margin, for example the LIBOR
d.The value that appears on the bond certificate, usually equal to £100
e.The contractual regular income the lender (or bondholder) expects to receive
f.Bonds that pay no interest during their term, are issued at a discount to par and redeemed at par on maturity
g.A special type of hybrid bond that gives the investor the right to exchange the debt for the equity of the issuer
- 1 = d
- 2 = a
- 3 = b
- 4 = e
- 5 = f
- 6 = g
- 7 = c