Bond Basics

A bond is an instrument of indebtedness of the bond issuer to the holders.

Basics

A Bond is a contract, between an entity taking the loan (issuing the bond) and another entity providing the loan. It denotes the indebtedness, and captures the necessary information on how much to pay back, and when.

Who issues bonds?

Companies that need capital (fancy way of saying access to large sums of money), can issue bonds. Central banks, like RBI or Federal Reserve or Bank of England, can and do issue bonds. Govt. of a country (GOI, for example) as well as state governments, can also issue bonds. Bonds are market-linked securities, just like stocks. Not unlike stocks, bonds also trade daily in exchanges (often called "secondary markets") such as NSE / BSE etc.

Why?

A company issues bonds to raise capital from the capital markets. It helps with their immediate need for cash. Which they would invest in growing their business. The belief here is they can generate much higher return than it'd cost to pay interest on that loan raised through bonds. Central banks, governments etc. do it for similar reasons as well; but instead of business growth, they're more focused on controlling flow of money within economy and issuing bonds in capital markets is how they start. The buyer of bonds is getting interest on money lent out against bonds.

Is currency a bond?

You might think that 10 rupee note in your pocket is a bond issued by RBI, because it clearly has the signature of RBI Governor, and some legalese printed on that. No, it's not a bond. Currencies are not bonds, even if they're issued by central banks.

History

Bonds were government debt instruments issued by the governments to finance government spending as an alternative to taxation. The first issued bond can be traced to Mesopotamia in around 2400 BC. The bond was backed by grain similar to how modern era secured bonds are backed by assets, as was customary of the time. Failure to repay the bond resulted in forfeiture of this surety. The staple currency in the era was corn. As loans were primarily taken to finance growing crop or herding cattle, interest payments were made in the form of the harvests of said crops. Over time silver became the dominant currency due to the perish-ability of other commodities. The modern form of bonds came to life when European merchants started lending to the aristocracy to fund sovereign spending.

What to look for?

Bonds can be issued by Governments (sovereign entities) or by corporates. Depending on that a lot of things will vary, including how risky the bond is but there are some things to keep in mind while looking at bonds which we will talk about in more depth as we progress in the series.

Coupon

Coupon is simply the rate of interest that the bond will pay out throughout its life. Depending on the type of the bond this can be fixed from the date of issue or keep on varying. Payment dates too can vary.

Yield

It is the rate of return. How does this differ from the coupon? Simply put not all bonds give out interest, some bonds instead are sold at a discount and you get a higher value back at maturity. Think of it like a cumulative FD if you may.

Yield to Call

A call option is a special provision in some bonds where the bond issuer has the special right to immediately pay off the bond. Think about how you might want to pay off a loan after getting a promotion with a large hike. Quite often a bond that offers a yield much higher than average will be "called" so it is prudent to check both the yield to maturity (yield which you will get if held till maturity) and yield until the date when the issuer has a right to call the bond. As an addendum there is another feature in some bonds called a put option which is the reverse ie it lets the bond holder force the issuer to pay the money back early, a premature FD closure if you may.

Credit Quality

As mentioned earlier not all bonds are made equal. Some bonds are riskier than others, this risk can be estimated by a "credit rating" which is a score that indicates how risky a bond is.