Understanding the Importance of Bonds in Finance

A bond is a long-term agreement under which a debtor reaches agreement to make payments of interest as well as principal; on set dates to the owner of the bond. Bonds in finance last for more than a year; and the principal as well as the interest is returned to the original owner of the bond eventually. Investors have a broad category when wanting to invest into bonds; but bonds are mainly categorized into 4 main types being:

• Treasury Bonds
• Corporate Bonds
• Municipal Bonds
• Foreign Bonds

Lets discuss each of the type of bonds in detail further

Treasury Bonds

Treasury bonds, or sometimes referred to as ‘government bonds’ are issued by the federal government with the aim of reducing its budget deficits; thus, used as a mean of financing by the government. These bonds are nearly risk free; however, the treasury bond prices may fall with the increase in interest rates; thus showing that they are not completely risk free. These bonds tend to give the lowest yields due to the lowest risk factor but; do perform better than the rest in times of economic declines.

Corporate Bonds

These bonds are issued by corporations to mainly raise capital. The mechanism of the corporate bonds works like other bonds in finance( the world of finance); while these bonds are exposed to default risk. The credit risk or default risk of each corporation differs as; the higher the credit risk, the more interest the issuer must pay. In simple terms- it’s like a higher reward for a higher risk.

Municipal Bonds

The municipal bonds or in short; the ‘munis’ are issued by the state or local government and have default risk like corporate bonds. An important factor of consideration is that the interest’ which is earned over municipal bonds is exempted from state and federal taxes; if the bond holder is a resident of the issuing state. Thus, leading to a lower interest rate carried by municipal bonds than corporate bonds; which have the same default risk.

Foreign Bonds

This security is of a different type from the rest of the bonds. Foreign bonds are issued by foreign companies or governments. Some of the foreign government bonds are default free while all foreign corporate bonds hold default risk. This type of bond involves currency risks thus exchange rates can control how a foreign bond performs; more than interest rates.

For example, if a U.S. investor purchases a corporate bond denominated in Japanese yen and if the yen subsequently falls relative to the dollar, then the investor will lose money even if the company does not default on its bonds. (EHRHARDT, 2011)

Check out the different types of foreign bonds here.

The 3 common characteristics almost all bonds share

Having looked at the main types of bonds; let us go through the main characteristics of bonds to understand bonds in finance even better. There are many types of bonds, but the following 3 characteristics are common among them all.

Par value

The specified face value of the bond is known as the par value.

Coupon interest rate

The interest payment size also called the coupon payment is fixed initially when the bond is issued; and remains applicable throughout the lifetime of the bond. However, in the case of floating-rate bonds; the rate is fixed for a time period; such as six months and is then adjusted for the next 6-month period, depending on the market rates.

Maturity date

Usually, bonds are to be repaid their par value on the specified maturity date. Basically- The day the bond is due. Most bonds tend to mature within 30 years of time (starting from the day the bond was issued); however, there are short term bonds as well which are usually called ‘notes’.

Calculating the bond value:

This formula will help you to calculate the bond value you are looking for-

Considering how individuals, firms and governments use bonds as a tool for financing; we have seen what bonds in finance means and how they work for the society. There is a lot of depth into this vital topic which you can further read about, understand and practice by Clicking here.

If you are interested in knowing more about finance, Help yourself with Fundamental Concepts of Corporate Finance