What is a Bond & How Do They Work?

What is a Bond?

A bond represents a loan obligation wherein a borrower agrees to pay a lender a specified interest rate known as the coupon rate in a specified time period or maturity (tenor).

These agreements are standardized with certain terms/conditions to help borrowers raise money on a large scale without negotiating with each individual investor separately.

Bonds are further characterized by the borrower and their statutory standing.

Governments, provinces, and municipal authorities are issuers of sovereign credit or sub-sovereign credit while companies are issuers of corporate bonds (investment grade/high yield).

Other notable issuers are Supranational entities (World Bank, European Investment Bank), Governmental Agencies (Canada Mortgage Housing Corporation) and other financial issuers of asset-backed securities.

How do Bonds Work?

Bonds are no different from mortgage liabilities of individuals, but apply to larger institutional issuers that make coupon or interest payments semi-annually and make principal payments at the end of the maturity period rather than on a predetermined amortization schedule as in the case of mortgages.

Further, mortgages are backed by real estate as collateral, but in the case of sovereign/sub-sovereign issuers, the taxing authority is the sole basis for guaranteeing payment of coupon and principal.

In the case of corporate issuers, these debt obligations can be secured against assets of the firm or unsecured in nature.

Municipal bonds can be project-specific and use the proceeds from the underlying infrastructure asset to pay back the bondholders or use the taxing authority to pay creditors when bonds are issued on a general obligation basis.

Finally, investors sometimes insist on having certain positive or negative assertions, forcing the issuers to perform or refrain from certain corporate actions.

These are referred to as covenants and pertain to the scope of further debt that issuers can or cannot potentially issue, and prioritize organizing cash flows to ensure the interests of debt holders aren’t compromised.

Bond Terms Explained

Coupon

Coupon or the rate of interest that the entity pays the bondholder semi-annually are a standard characteristic of most fixed-income securities.

These rates are often a function of the credit quality of the issuer, length of the borrowing period, existing investor expectations or bond yields and other idiosyncratic factors related to the specific bond issue.

Maturity or Tenor of Issue

Maturity or tenor of a bond indicates the period after which the principal is repaid to the bondholders.

This is also indicative of interest payment dates for any given bond issue.

Active debt market issuers such as Governments, Provinces, certain corporate issuers like financial institutions, telecom companies or Supranational entities have a number of bonds outstanding across the maturity horizon.

This means they bring new issues or re-open existing bonds for different sectors (5, 10, 30 years) based on their borrowing requirements and broader institutional investor demand.

Frequent new issues engage broad investor participation and ensure that there is sufficient liquidity in the secondary marketplace for specific active issuers, enabling them to raise financing at attractive rates.

Yields

Yields reflect the investors’ expectations of their desired return by investing in a particular bond issue.

These are often a function of several factors such as credit rating of the issuer, maturity/tenor of issue, underlying liquidity of the issue, inflation expectations and other idiosyncratic features pertaining to that particular issue such as structural subordination (bonds issued by the holding company vs. bonds issued by the operating company).

Covenants

Based on where debt lies in the capital stack, the upside to bondholders is the payment of coupons and repayment of the principal amount while equity holders have uncapped upside.

Covenants are certain terms and conditions that exist to protect the financial interest of bondholders and ensure that issuers don’t incur additional debt liabilities or divert cash flows to equity shareholders ahead of debt holders.

These can be affirmative or restrictive in nature.

Examples of such covenants are: (i) “issuer will make timely coupons” or (ii) “issuer won’t let the debt coverage ratio exceed 3.5x”.

Most covenants focus on the following:

  • Limitations on Incurrence of Indebtedness
  • Limitations on Restricted Payments
  • Limitations on Liens
  • Limitations on Restrictions on Subsidiary Distributions
  • Limitations on Asset Sales

Call Protection

Most bonds are expressed in the following format – RY 2.25 10NC5 03/15/2032 – which is explained below:

Name of the Issuer: RY or RBC
Coupon: 2.25% paid semi-annually
Maturity: March 15th, 2032
Call Protection Period: Optional, not all bonds are callable early – 10 non-callable for 5 years or 10 Not Call 5 in this case (10NC5).

This call protection period limits the ability of the issuer to call the paper for redemption earlier than maturity in the event that interest rates drop significantly and make refinancing attractive for the issuer, but increase the reinvestment risk for bondholders.

Further, once the non-callable period elapses, the bond indenture (agreement) specifies the call premium issuer pays to retire the outstanding bonds.

Finally, certain issuers incorporate make-whole provisions which allow an issuer to entirely avoid the call structure issue by defining a premium to market value that will be offered to bondholders to retire the debt early.

Common Types of Bonds

There are many different types of bonds. Here are a few common ones:

Zero-Coupon Bonds

Zero-coupon bonds are fixed income securities that don’t pay a coupon as the name suggests, but are priced at a certain discount to their face value or the principal amount received upon maturity.

Usually, treasury bills and money market instruments are priced using this method.

Longer-term products exceeding 1 year in tenor will often pay a coupon.

Having said that, these instruments are fairly liquid and pose limited default risk as issuers are Government/Sub-Sovereign issuers in most cases.

Asset-Backed Securities

Investors like buying loans, credit, and debt obligations from financial institutions, banking companies and commercial credit originators.

However, they don’t want to deal with borrowers individually to collect interest and service the debt.

Structures such as ABS (Asset-Backed Securities) provide a separate legal entity that holds all these credit obligations and issues securities against such financial assets.

After the financial crisis, these often get a bad rap, but the underlying mechanism behind these structures is sound and any adverse results reflect on the collateral infused into these offerings.

Real Return Bonds (RRBs)

RRBs are Canadian government bonds that provide protection against inflation.

These bonds make coupon payments by modifying the interest rate, as well as, the principal amount using the current Consumer Price Index (CPI) to ensure that the bonds maintain their purchasing power.

Convertible Bonds

These fixed-income securities provide the issuer with the flexibility to convert the principal outstanding into shareholders’ equity at a predetermined rate outlined by the bond indenture, prior to the maturity of the issue.

Such issues are often priced at a premium as investors demand additional compensation for investing in such hybrid securities.

Payment in Kind Bonds (PIK)

These bonds are products that make coupon payments in issuers’ bonds instead of cash and these coupons are sometimes added to the principal amount payable on maturity.

Such structures allow issuers to preserve cash in the short run and allow investors to pick up extra yield for taking an incremental risk on the issuer.

Advantages of Investing in Bonds

Risk Parity Characteristics

Fixed income securities are fundamental blocks of creating a defensive portfolio.

Bridgewater Associates – the world’s largest hedge fund – have famously used bonds as the defensive lever for their risk parity portfolio construction purposes.

Bonds go up in value in a flight to safety event while equities lose value in a risk-off move.

Sovereign debt is a great tool to build this intrinsic resilience into your portfolios.

Portfolio Diversity and Objectives

As investors are now looking to allocate capital and use said capital to bring a positive change in the world, green bond offerings provide a great opportunity to invest in sustainability-linked notes issued by World Bank and other such agencies.

Further, a small bump in price is attributed to investing in these bonds and is referred to as the “greenium” which makes it attractive for investors.

Structured Credit

By creating a pool of assets, issuers are able to manufacture fixed income products with certain risk profiles and characteristics that appeal to the investing community and fill a hole in their fixed-income portfolio holdings, as well as facilitate liability-driven investing flows.

Reviewing corporate statements for bond issuance

Disadvantages of Investing in Bonds

Inflation Risk

Sovereign nations that borrow in their domestic currency have the luxury to print more fiat currency in order to pay borrowed funds, but as money supply increases, it adds upwards pressure to the costs of goods and services, which can be considered as inflationary in nature, thereby devaluing coupon payments.

Prolonged periods of inflation will significantly affect the real value of principal repaid upon maturity.

Large Notionals

As fixed income markets are dominated by institutional money, retail investors might find barriers to entry as most bonds have a large face value ($1 million or more).

Fixed-income ETFs are a good way to get exposure to these securities for smaller nominal amounts or ticket sizes.

Limited Number of Issuers

While debt capital markets are deep and function well in Canada, certain issuers issue sporadically and their new issues get oversubscribed by multiples of the offered size, thereby pricing these securities at a premium.

Investors can invest south of the border as the US boasts some of the most liquid corporate credit markets in the world and investors can get better value if they can navigate through the incremental currency risk exposure.

How are Bonds Priced?

Sovereign credit or Government Bonds are priced based on the current investor expectations of the repayment ability of the issuer, the tenor of the issue, underlying liquidity in that part of the yield curve, forward inflation expectations and other factors relating to the specific issuer or debt offering.

A certain rule of thumb while pricing bonds is that if the coupon rate is greater than the yield, then the bond’s value would be more than the par value (face value of the bond or amount borrowed per bond) and vice versa.

For bonds issued by companies (corporate credit), these securities are priced based on the issuer’s creditworthiness.

Each company is assigned a letter grade, which is similar to a credit score given to individuals.

Companies that have a lower chance of default are called investment grade and are often well-established companies.

Those issuers with ratings below BBB- are considered non-investment grade or high yield issuers.

Canadian credit markets usually see issuers in the 7 to 10 year space and capital markets activity is limited in the long end of the curve.

Yields are calculated as a spread that is added to the underlying Government of Canada bond for the same maturity.

This spread represents the premium that investors demand to get compensated for taking exposure to this particular credit versus lending to the Canadian government for the same term.

What is a Bond Rating?

Bond ratings are a tool to simplify and assess the risk of default for a particular issuer or issue.

Credit ratings are a function of several factors such as size, industry, management, credit ratios, financial ratios and other factors.

Issuers that are assigned lower credit ratings often have volatile cash flows, levered balance sheets, and/or cyclical business models, and thereby have to offer higher coupon rates to compensate investors for the added risk.

Frequently Asked Questions

  • What is a bond in simple words?
  • What is the purpose of bond markets?
  • What is an example of a bond?

Sid Mohapatra is an energy trader based out of Toronto working in power and natural gas trading. Prior to working in commodities, Sid worked at a top Canadian bank’s fixed income and derivatives business. He possesses strong fundamentals in asset allocation, global macro thematic investing and physical commodities.

As a graduate of McMaster University, Sid specialized in Finance and has taught numerous sessions on Investing, Financial Securities and Trading courses. He led and managed the Horizon’s Trading Center at McMaster University.

Sid’s unique experience brings a breadth of institutional knowledge to the retail investing universe. He covers equity derivatives, structured credit instruments and tax harvesting techniques to help Canadians make better financial decisions in the ever-changing landscape of financial markets and investing.