A bond is a borrowing (or lending) and is a loan in structure.
Let us look at a loan transaction.
Lender: Gives Money. For a period of time. At a rate of interest.
Borrower: Borrows for this period of time. Has to pay regular interest and finally the principal amount at maturity.
What are the challenges?
Lender does not get his money till maturity – Liquidity Risk
This is the chief problem in a loan transaction which is one to one (OTC).
Borrower may default – Credit Risk. We will look at this later.
What is a Bond?
A bond also called a Fixed Income Security .
- A bond is a ﬁnancial security that promises to pay a ﬁxed income stream at fixed dates in the future
- Issued by governments, state agencies municipalities and corporations
- When a corporation or government wants to borrow money, it often sells a bond
So we have the issuer of a bond (borrower) and the investor of the bond (lender)
The borrower promises to give the investor:
- Regular interest or coupon payments every period until the bond matures.
- The face value of the bond when it matures
Bonds are characterized by
- Maturity date
- Face, par or principal value
- Interest Rate (or Coupon Rate)
- Number of interest payments per year (typically 2; also called coupon payments)
Loans are classified by the initial maturity or tenor of the borrowing
Loans are also classified by the Issuer of the loan
Combining the two we see a loan has two key principal characteristics – issuer and duration of borrowing
What are the benefits of bonds to investors?
- Investors receive ‘coupon’ also known as the interest payment.
- On maturity, investors receive back the principal which they had originally invested
- Depending on the quality of the borrower, the investor derives a measure of comfort regarding the safety of his investment.