from an investor's point of view, it is an investment and from a company’s point of view, the bond or debenture falls under the liabilities section of the balance sheet under the heading of Debt. A bond is similar to the loan in many aspects however it differs mainly with respect to its trading nature. A bond is usually tradable and can change many hands before it matures; while a loan usually is not traded or transferred freely.
The bonds are divided into two main categories:
Government Bond:
The central or state government issues bond, popularly known as government securities (G-secs) or gilt-edged securities. These are issued by the central bank of the country on behalf of the Government, for medium to long term, on which interest is paid on a half-yearly basis. Bonds issued by the government are considered risk-free.
Corporate Bond:
When public companies issue bonds, they are known as corporate bonds. When it comes to the international market, a secured corporate debt instrument is known as a corporate bond, but in the case of the unsecured debt instrument, it is known as a corporate debenture. Because bonds issued by the corporates are exposed to risk. In India, corporate debt instruments are termed as debentures.
Features of Bonds
- Rating Every bond is usually rated by credit rating agencies; higher the credit rating lower will be the coupon required to pay by the issuer and vice versa.
- Par value refers to the value stated on the face of the bond, which shows the amount which the company or government body promises to pay at the time of maturity.
- Coupon Rate is nothing but the fixed rate of interest payable to the bondholder.
- Maturity Date is the date at which the bond gets matured, and the principal amount is paid to the bondholder.
- Redemption value is the value paid to the bondholder, at the time of expiry of the term for which bond is issued.
Valuation of Bonds
Bond valuation is used to calculate the fair value of the Bonds, For bond valuation :
- First, understand the Cash Flow pattern of the bonds.
- second, decide the appropriate discounting factor for the bonds.
- lastly, discount the cash flow using a discount factor.
NOTE: Use annuity for valuating long term bonds
Type of Bonds
1. PLAIN VANILLA BONDS
It is one of the simplest forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond.
2. ZERO COUPON BONDS
A zero-coupon bond is a type of bond where there are no coupon payments made. It is not that there is no yield; the zero-coupon bonds are issued at a price lower than the face value (say 80$) and then pay the face value on maturity ($100). The difference will be the yield for the investor. These are also called as discount bonds or deep discount bonds if they are for longer tenor.
3. DEFERRED COUPON BONDS
This bond is a blend of a coupon bond and a zero-coupon bond. These bonds do not pay any coupon in the initial years and thereafter pay a higher coupon to compensate for no coupon in the initial years. Such bonds are issued by corporates whose business model has a gestation period before the actual revenues start. Examples - construction companies.
4. STEP-UP BONDS
These are bonds where the coupon usually increases after a certain period. They may also be designed to increase not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to grow in a phased manner. These are also called as a dual coupon or multiple coupon bonds.
5. STEP DOWN BONDS
These are just the opposite of Step-Up Bonds. These are bonds where the coupon usually reduced after a certain period. They may also be designed to reduce not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing.
6. FLOATING RATE BONDS
Floating rate bonds are so-called because they have a coupon that is not fixed but rather linked to a benchmark. For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps (100 bps = 1%), In such cases on every interest payment date, the payment will be made 0.50% more than the treasury bill rate prevailing on the fixing date.
7. INVERSE FLOATERS
These types of bonds are similar to the floating rate bond in that the coupon is not fixed and is linked to a benchmark; however, the differentiating thing is that the rate is inversely related to the benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes down and vice versa.
8. PARTICIPATORY BONDS
A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon cash flow may increase if the profit/income levels of the company rise to a pre-specified level and may reduce hen income falls below a pre-specified level: thereby the investor participates in the return enjoyed based on company revenue/income.
9. INCOME BONDS
Income bonds are similar to participatory bonds however these types of bonds do not have a reduction in interest payments if income/ revenue reduces.
10. PAYMENT IN KIND BONDS
These types of bonds pay interest/coupon, not in terms of cash payouts but in the form of additional bonds.
11. EXTENDABLE BONDS
Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity if required. The holder has an additional benefit in this case because if the rate of interest in the market reduces, the holder may choose to extend the tenor and enjoy the higher rate of interest in terms of coupon payment. For this benefit, the holder may enjoy the coupon rates that are usually lower than a plain vanilla bond.
12. EXTENDABLE RESET BONDS
These are types of bonds that allow the issuer and the bondholders to reset the coupon rate based on the then prevailing market scenario. This is not linked to any benchmark but on the basis of renegotiation between the issuer and the bondholders. This is usually the case where the bond tenor is very long.
13. PERPETUAL BONDS
These types of bonds pay a coupon rate on the face value until the life of the company. Though Perpetuity means forever, bonds with maturity above 100 years are also considered to be perpetual bonds.
14. CONVERTIBLE BONDS
Convertible bonds are a special variety of bonds that have an inbuilt feature of being converted to equity shares at a specified time at a pre-set conversion price.
15. FOREIGN CURRENCY CONVERTIBLE BONDS
A foreign currency convertible bond is a special type of bond issued in the currency other than the home currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency.
16. EXCHANGEABLE BONDS
These bonds are similar to the convertible bonds but differ in one aspect that they can be exchanged for equity shares but not of the issuer. These can be exchanged for equity shares of another company which the issuer may have stakeholding.
17. CALLABLE BONDS
Bonds that are issued with a specific feature where the issuer has the right to call back the bonds at a pre-agreed price and a pre-fixed date are called as callable bonds. Since these bonds allow a benefit to the issuer to repay off the liability before maturity, these bonds usually offer a coupon rate higher than a normal straight coupon-bearing bond.
18. PUTTABLE BONDS
Bonds that are issued with a specific feature where the bondholder has the right to return back the bonds at a pre-fixed date before maturity are called puttable bonds. Since these bonds allow a benefit to the bondholders to ask for the principal repayment before maturity, these bonds usually offer a coupon rate lower than a normal straight coupon-bearing bond.
19. TREASURY STRIPS
In the US, Government dealer firms usually break down a coupon-bearing bond into a series of zero-coupon bonds by considering each cash flow as a separate bond. For example, a 5-year semiannual coupon-bearing bond can be split into 10 zero-coupon bonds with coupon amount as face value and 1 zero-coupon bond with the principal amount as the face value. Bond stripping usually is done to increase liquidity and facilitate easily traceability.
20. YANKEE BONDS
A dollar-denominated bond issued in the US by an issuer who is outside the US is called a Yankee bond.
21. SAMURAI BONDS
A yen-denominated bond issued in Japan by an issuer who is outside Japan is called a Samurai bond.
Shogun Bonds: A non-Yen denominated bond issued in Japan by an issuer who is outside Japan is called a Shogun bond.
Bond Valuation
For example, if a bond issuer promises to pay an annual coupon rate of 5% to bondholders and the face value of the bond is $1,000 and maturity of 5 years, the bondholders are being promised a coupon payment of (0.05)($1,000) = $50 per year. and repay $1000 at the end of 5th year. Cash flow table will be like the below:
Cash Flows ($):
Year 1 Y1 Y2 Y3 Y4 Y5
$50 $50 $50 $50 $1050
Discounting Factor
For valuing the above bond using the present value technique, it is of utmost importance to find the most appropriate discounting rate. For example, let’s consider the above bond is issued by a government agency and there is another government agency offering another bond at 5%. Since the bonds are issued by the government agency, they are almost risk-free, or at least both of them assume the same level of risk. We can safely use 5% as our discounting rate because you can invest in a 5% bond if you do not invest in the higher interest i.e. 6% or 7% bond and therefore the interest of 5% bond is your opportunity cost.
Market Value of the Bond
Once we have determined the most appropriate discounting rate for our situation, the rest of the steps of valuation are very easy. We will now find the present value of the future cash flows or discount the cash flows based on the discounting rate and add all of them. The result will give you the valuation of a 5% bond i.e. the intrinsic value of the bond which can be construed as an ideal market price of the bond.
Intrinsic Value of Bond = 50/1.05^1 + 50/1.05^2 + 50/1.05^3 + 50/1.05^4 + 1050/1.05^5
Intrinsic Value of Bond = $1000
USING ANNUITY FOR VALUING LONGER TERM BONDS
The problem in the calculation will appear if the bond is of say 20 years. An annuity is a solution, for that. We will break the cash flows into two – the coupon payments and the principal repayment. We will find the present value of coupon payments using the annuity method and the principal will be discounted using the normal method. Let’s use this method for the above calculations:
Present Value (PV) of Bond = PV (Coupon Rate) + PV (Principal)
= Coupon Amt. * 5 Yr. Annuity Factor + Principal * Discount Rate
= 50 * 4.3295 + 1000 * 0.7835
= 999.975 ~ $1000
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