“Bond” is a word that is mostly confined in to those “in the know” of business, finance, and economy circles. Those who are not fluent in the business language may have heard or seen the word “bond” a couple of times when skimming through the news or within earshot at banks or casual business discussions and meetings in public places, such as in trendy cafes. But what exactly are bonds? Why does this word carry so much importance in the world of business and finance? In today’s article, we shall look in-depth (but in simple terms) into the basics of and everything you need to know about bonds.
What is a Bond?
In simple words, a bond is a document or a contract that has been drafted and officially signed by two parties. A bond is often used by companies, financial institutions, and governments (i.e. the issuers, borrowers, or debtors) when they need to borrow large sums of money from investors (i.e. the lenders or creditors). Therefore, a bond is a legally binding agreement issued by the company, financial institution, or government that promises to repay money lent to them from investors at a fixed rate of interest and at a particular time.
Another important thing to remember is that bonds are different from stocks. While both act as a form of security to the borrowers, its functions differ vastly. For example, when an investor purchases a share of stock from a company, they are entitled to own their share of equity in the company and will receive the dividends paid by the company. On the other hand, bonds do not allow the investors to own equity in the company. The investors will only receive the interest and the principal (i.e. the original amount of money put into the investment), regardless of whether or not the company becomes profitable or whether the prices of their stock increases. Nevertheless, in the case of bonds, the company will still have a legal obligation to make interest and principal payments on time even if the company faces financial difficulties. For stocks, however, the company is not obligated to pay dividends to the stockholders. Thus, in the event of a company’s bankruptcy, the bond investors have more rights than and priority over stockholders in claiming the company’s assets.
Why are bonds important to the issuers?
Bonds are often needed and useful for borrowers who need large sums of money from investors to finance long-term investments (i.e. for companies) and current expenditures (i.e. for government bonds). The money borrowed is also used to pay off a company’s or a country’s debt and invest in development projects, such as building schools, hospitals, office buildings, roads, etc.
Different types of Bonds
There are many types of bonds which has its own purpose, holding varying fixed interests, in addition to the level of risk attached to them. Below are three of the most common types of bonds used in Malaysia.
- Corporate Bonds
A corporate bond is a bond issued by a company to raise capital for purposes such as expanding their business, purchasing equipment, and building or improving facilities. Here, the investor buys a bond or lends money to company that issued it. The company then promises to repay the principal on a specified maturity date. In the meantime, the company also pays a specific rate of interest. In Malaysia, for instance, Bank Negara Malaysia (BNM), or the Central Bank of Malaysia, is a government agency which is responsible for issuing corporate bonds.
- Government Bonds
A government bond is a debt or debt security issued by a government to support government spending. In other words, the government issuing the bond is accepting a loan. The interest payments paid periodically on this type of bond are called coupon payments. In Malaysia, there are two types of government bonds that help in raising capital: they are a) Malaysian Government Securities (MGS), and b) Government Investment Issues (GII).
MGS is a conventional coupon-bearing, long-term bond issued by the government to raise funds for expenditures relating to development. They are the most actively traded bonds. GII, on the other hand, is long-term non-interest-bearing government securities based on Islamic principles issued by the Malaysian government for funding developmental expenditure. GII are issued through competitive auction by BNM on behalf of the government.
- Mortgage bonds
A mortgage is essentially a loan to buy a property. With a mortgage, the bank is usually the main investor. However, with a mortgage bond, investors can invest in it. The mortgage can be invested in because the bank sells the mortgage to an investment bank that creates a bond. Cagamas Berhad (the National Mortgage Corporation of Malaysia) is a secondary mortgage corporation which helps investors through the issuance of corporate bonds and sukuk “to finance the purchase of housing loans and receivables from financial institutions, selected corporations and the public sector”. Mortgage bonds tend to have lower yields due to lower risks. The mortgaged property is thus guaranteed as collateral.
Basic terminologies used when discussing bonds
In trying to familiarize yourself with the discussion of bonds, there are some basic terminologies that need to be understood. Here are some of the most commonly used basic terminologies.
- Par Value
The par value is also known as the face value of the bond, which is the amount that is returned to the investor when the bond matures.
Bonds that do not necessarily trade at their par values may trade above or below their par values.
The maturity of a bond refers to the length of time until the bond is owed and the investor receives the par value of the bond.
- Coupon bond
A coupon or bearer bond is a bond with a certificate that has small detachable coupons. The coupons entitle the holder to interest payments from the borrower.
- Coupon Interest Rate or Coupon Yield
The coupon interest rate is the rate that the issuer of the bond promises to pay the investor.
This is a general term that relates to the return on the capital you invest in a bond.
- Current yield
This is the bond’s coupon yield divided by its market price.
- Yield-to-Maturity (YTM)
The rate of return you receive if a bond is held to maturity and reinvested in all the interest payments at the YTM rate. This is calculated by taking into account the total amount of interest received over time, purchase price (the amount of capital invested), the face value, the time between interest payments, and the time remaining until the bond matures.
- Yield-to-Call (YTC)
The yield of a bond, if the security were to be bought and held until the call date. This yield is valid only if the security is called prior to maturity. The calculation is based on the coupon rate, the length of time to the call date, and the market price.
- Yield-to-Worst (YTW)
The lowest yield that can be received on a bond.
Now that we have come to the end of our basic lesson on bonds, let us go through a summary of the key points. Firstly, bonds have the same function as loans. When you buy a bond, you lend money. Therefore, bonds are considered debt, whereas stocks are equity. The issuers of bonds are usually governments, corporations, and financial institutions. The three main types of bonds commonly issued in Malaysia are corporate bonds, government bonds, and mortgage bonds. Bonds are described using terminologies such as face value, coupon interest rate, maturity, and yield. These terminologies denote the characteristics of the bond, based on their appropriate calculations.