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Bond (finance)

A bond or debenture is a debt instrument that obligates the issuer to pay to the bondholder the principal plus interest. Thus, a bond is essentially an I.O.U. issued by a private or governmental corporation -- that corporation "borrows" the face amount of the bond from its buyer, pays interest on that debt while it is outstanding, and then "redeems" the bond by paying back the debt.

Bonds are securities but differ from shares of stock in that stock is an ownership interest (termed "equity"), but bonds are merely "debt": Therefore a stockholder is an owner, but a bond-holder is merely a creditor.

"Convertible bonds" or "convertible debentures" are those that can be converted into some other kind of securities, usually common stock in the corporation that issued the bonds.

"Subordinated bonds" are those that have a lower priority than other debts of the issuing corporation, so if there is not enough money to pay all the company's debts, the "senior" (= higher-priority) ones get paid first, and the subordinate ones get paid out of what, if anything, is left.

Bonds are issued by the government or other public authorities, credit institutions, and companies, and are sold through banks and stock brokers. They enable the issuer to finance long-term investments with external funds. The total volume of a bond issue is the sum of the individual bonds.

The most important features of a bond are its initial value, known as the "par value," its maturity date, the "coupon" or "nominal yield," effectively the interest rate, and whether the interest rate is fixed or floating.

The rights of a particular bond issue are specified in a written document, usually called an "indenture," and federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. Those terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bondholders.

Interest is paid on the first "coupon date" and subsequently on coupon dates at regular intervals, if the issuer has the money to make those payments then. If the interest ("coupon") payments have not all been made when due, and so are in arrears, the issuer must also pay those back-due amounts when it redeems the bond, in addition to the principal ("face") amount.

The bond may have a "call" provision that allows the issuer to pay back the debt (= "redeem the bond") before its nominal maturity date but, even when there is no such provision requiring a holder to let the issuer redeem a bond before its maturity date, the issuer may offer to redeem a bond early, and its holder may accept or reject that offer.

Bonds classified according to various categories:

  • Fixed-rate bonds[?], where the interest rate remains constant throughout the life of the bond.
  • Floating-rate bonds[?], with a variable interest rate that is tied to a benchmark such as a money market index[?].
  • Zero-coupon bonds, which do not bear interest, as such, but are sold at a substantial discount from their par value. The bondholder receives the full face value at maturity, and the "spread" between the issue price and redemption price is the bond's yield. (Series E savings bonds from the U.S. government are zero-coupon bonds.) Zero-coupon bonds may be created from normal bonds by finance institutions "stripping" the coupons (the interest part of the bond) from them - that is, they separate the coupons from the principle part of the bond and sell them independantly from each other.
  • Inflation Indexed bonds[?], in which the principle (or "face" value) is indexed to inflation. TIPs and I-bonds are examples of inflation indexed bonds issued by the US governmnet.

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. Since these factors are likely to change over time, the market value of a bond can vary after it is issued.

The market price of a bond may include the accrued interest[?] since the last coupon date (possibly some bond markets include it in the trading price and others add it on explicitly after trading). The price including accrued interest is known as the "flat" or "tel quel price[?]," although it will presumably fluctuate with the interest payment period. (See also Accrual bond.)

The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).

Taking account the expected capital gain[?] or loss (the difference between the current price and the redemption value[?]) gives the "redemption yield": roughly the current yield[?] plus the capital gain (negative for loss) per year until redemption.

High-yield bonds (with a correspondingly high risk) are sometimes known as junk bonds. Bonds issued by the government of the United Kingdom in sterling are known as gilts[?].

Bonds may be issued by various types of institution:

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