Bonds can variously be described as IOUs, loans or debts. They are similar to bank loans, but generally last longer (from 1 year to over 30 years).

When institutions, companies, governments and other entities want to raise long term finance but do not want to dilute their share holdings (or, indeed, cannot issue share capital ─ like the UK Government), they turn to the bond markets. Here they can raise money without having to pay it back for possibly decades.

On the other side of the deal are the investors. The biggest investors in the UK are the insurance companies and pension funds. They buy bonds to generate return, offset their liabilities, generate income or diversify their portfolios.

History

Before electronic ownership of bonds became common in the latter part of the twentieth century, when an institution issued bonds, the lender received a certificate. This was often a very elaborate and large document with pictures of whatever the bond was financing (trains, factories, airplanes etc). Amongst other information it also showed how much the certificate was worth (i.e. how much had been borrowed), the rate of interest, the currency and the borrower.

At the bottom of the certificate were a number of “coupons” attached to the main body by perforations (like stamps). Periodically, the lender would go to the paying agent (the company employed by the borrower to facilitate payments to bonds holders) with the certificate; the paying agent would tear off the relevant coupon and hand over the interest payment. At maturity, the whole certificate would be presented, the “principal” (or nominal amount) of the loan and final coupon paid and the certificate cancelled. We still use this slightly archaic terminology today, referring to “coupons” and “principal” even though virtually all bonds are now held electronically.

Risk Features

When an investor thinks about purchasing a bond, there are four key risk attributes that they will assess to determine whether the bond is a good fit with their portfolio, how likely it is that the expected returns will be achieved and whether the price is fair. These attributes are:

• its issuer
• its currency
• its coupon
• its maturity

Issuer − The issuer of the bond (i.e. borrower of the money) defines the credit risk of the bond. That is, the likelihood that the investor will be repaid their initial loan. For example, governments are generally considered to have a low credit risk.

Currency − A key difference between equity and debt is that, unlike equity, institutions can issue bonds in many currencies. Indeed bond markets talk about the currency of issuance and not the country of issuance. For instance, Vodafone, with its equity listed in London, issues debt in six currencies including the Australian dollar and Czech Koruna. The currency of the bond defines the second key risk characteristic of the bond.

Coupon − The coupon or interest rate defines the rate of interest paid on the bond. This interest can be paid annually, semi‐annually or even every 3 months, depending on the way the bond is structured. The stated rate of interest relates to the original amount of money lent or the “face value” of the bond and is more often than not a notional value of 100 or “par”. This is often not the same as the price paid for the bond. The size of the coupon gives an indication of the credit risk of the bond. The higher the coupon, the greater the riskiness of the issuer as an investor will require a higher interest rate to compensate them for the greater likelihood of the issuer defaulting.

Maturity − The maturity date is the date the investor gets their money back. There are a number of subtleties around the maturity date, but most bonds have a single fixed date. The further in the future the maturity date (the “longer” the bond), the more risky the debt as there is more time for the issuer to get into trouble. Indeed, some bonds (including the famous war loan from the UK Government) are “undated”, which means that the issuer never has to repay the debt. Undated, or perpetual, bonds often have features that allow the issuer to pay back the debt under certain circumstances: these are called “call options” and give the issuer the right, but not the obligation, to pay back the lender.  The UK War Loan is undated and has a 3.5% coupon rate that is paid semi‐annually. However, since 1952 the Treasury has been able to “call” the bond and pay back investors at a price greater than 100 (or Par). Unfortunately, even during the deflationary hiatus of January 2006 the price of the bond only rose to about 94 with a yield of 3.7% so the bond was not called. War loan investors are therefore very unlikely to get their money back (ever)!

Legal Status and Growth Participation

There are three broad ways in which a company or institution can raise money: through the equity markets, the banks or the bond markets. Each of these has their own merits as shown in Table 1.

In terms of legal status and growth participation, bank loans and bonds are very similar. The main two differences are the length of the borrowing and what rights the lender has if the company goes into bankruptcy. Banks loans are often much shorter in maturity than bonds and banks usually get their money back before bond holders.

The key differences between bonds and equity is that most equity has voting rights and participates in the growth of the company (i.e. shares in the upside), whereas debt has neither voting rights nor the ability to participate in the company’s growth. However, debtors do have the ability to call in the administrators if the company defaults on a payment or breaks a covenant — a legally binding promise made by the issuer to the investor in the prospectus -and possibly close down the company.

They also have an earlier call on the company’s assets. So if the company does default, the bond holders often get something back whilst the equity holders get nothing. Indeed in this scenario the bond holders usually end up owning the company. In bond market language this means that the debt holders rank “above”, are “higher” or “senior” to the equity holders.

Table 1

BROAD CHARACTRISTICS