Bonds as Financial Instruments and Their Functions - Essay Example

Student’s name: Tutor’s name: Institution: Date: Bonds as financial instruments and their functions Bond refers to long-term contracts in which the borrower accepts to make principal and interest payments at specific dates to the creditors (holders) of the bond (Asquith et al. 2013). Bonds exhibit various characteristics most of which can be used in describing them and theirs significances within the economic panorama. Bonds are considered financial statements due to the characteristics and their nature of handling within the books of account deciphers accounting records. As financial instruments, the bonds tend to play a significant role within the economic perspective. Thus, each of these roles can be analyzed in terms of the characteristics exhibited (Walmsley 2009). One way in which the bond can be characterized is the bearer bond. Such bonds are those that are not recorded in the issuer’s book. The bonds are thus under the custody of the owner in physical form. The owner receives the bond interest payment through the physical detachment of the coupons from the bond certificate and presenting them to the paying agent. The registered bond, on the other hand, refers to a case where the issuer records down the interest payments and the ownership (Pascarella & Raymond 2010). Bonds are equally characterized by the par value. This is the face or maturity value and is described as the amount that the issuer accepts to pay upon the maturity date of the bond. The coupon interest rate is also an attribute of bonds. It is the stated interest rate percentage and is usually paid semiannually. Relatively bonds have a maturity date. This is the date in which the principal amount or the other debt instrument becomes payable. Bond indenture plays a role in establishing the promises of corporate as well as the rights of the issuer (Chalmers 2008). In addition, there are more characteristics of bond that makes them appear as financial instruments. Call provision is an option that grants the bond issuer rights to partly or wholly buy back the bond issue before maturity. Bonds have the element of sinking fund. The sinking fund is the funds to which is often added and then used in ensuring investor confidence, by providing assurance that the payment will be made and that such payments would redeem debt securities. Subsequently, the bonds can further be classified as convertible bonds. This is a general debt obligation that can be traded for a number of shares from the Issuing Corporation and done using the pre-stated conversion price (Asquith et al. 2013). Finally, there is the element of the warrant. This is a security entitling the bond holder to acquire a proportionate amount of stock at a given period in the future at a specific price, often quoted above the market price. The warrants are thus traded as securities whose price is a reflection of the underlying stock value (Blanchard, Giavazzi, & Sa 2005). All the above-mentioned characteristics are indicators that bonds are financial instruments used by corporations and other financial institutions. The element of borrower and issuer explicitly points out to the fact that financial transactions are underway. Moreover, the manner in which the transactions are handled deciphers elements of the transaction and financial elements (Huefner 2010). Corporations and governments within their capacities often borrow money from people to enable them to finance the various projects underway. The governments and corporations require funds to cater for operational expenses, and general running. They, therefore, have the option of borrowing from the investors in the form of bonds. In various instances, bonds often consider income investments because, after using your money, the issuer accepts to make the certain interest payment at regular intervals for a set period to maturity. Bonds play significant roles in the running of an organization or government system. For instance, they can be a reliable, current income source depending on the bond structure purchased. This implies that the bonds are the finances, which help in running of the organization. Relatively, the bonds offer an element of liquidity since the bond market is wide and active. Relatively, selling a bond before its maturity may lead to receiving more or less the principal investment since the bond values often fluctuate (Walmsley 2009). The interest income obtained from the federal government bonds is often exempted from tax within the local or state levels. This means that the final amount is often high and of great worth. While weighing on the investment spectrum, the investment grade bonds posses low-risk investment. They are thus perfect investment options and may help a great deal in ensuring that good returns are achieved. As financial instruments, the bonds support companies and government in managing their services. As such, the companies operate smoothly through the bonds. Relatively, the bond issuers also benefit the interests earned upon the bond maturity. Bonds can be classified into various types. In fact, the large majority of the bonds can be categorized into four major categories, namely, the US government bonds (Treasuries), the agency bonds, the municipal bonds, and the corporate bonds (Huefner 2010). The US government bonds refer to the outstanding debts, most of which is issued in the form of bonds. The bonds are given in the form of Treasuries. The major difference between the treasuries and other bonds is that the US government, specifically issues them and thus stable in value. The agency bonds, on the other hand, are issued by institutions created by the government to play important roles such as the provision of student loans and fostering of home ownership. The primary government agencies, mainly constitute Fannie Mae, Ginnie Mae, Freddie Mac, and Sallie Mae (Ambrose & Warga 2009). Despite the agency's operation like the corporations, they are perceived to be backed by the United States government. Municipal bonds are mainly issued by the local government, though on a smaller scale. The municipal bonds are used in funding a variety of projects such as the toll roads, the police department, and the fire department, among others (Lamb, Lamb, & Rappaport 2011). The municipal bonds are highly popular among individual investors since they offer tax advantages that are not offered by the other types of bonds. Like the treasuries, the municipal bonds are tax-free (Kamara 2012). The major strategy for investment in the municipal bonds is often to acquire bonds with attractive interest rates and holds the bond until maturity. This is then followed by sophistication in which a municipal ladder is established. The ladder comprises of various bonds each having a different interest rate as well as maturity date (Chalmers 2008). The last category of bonds is the corporate bonds. This is where companies choose to issue out a bond in order to raise capital to improve businesses. Corporate bonds are often given under various circumstances. Such may include while paying dividends to its shareholders, during expansion, purchasing another company, or during expansion (Bao, Pan, & Wang 2011). Corporate bonds are often distinct from other types of bonds in that there are almost taxable at state and federal levels. Who are the buyers of the bonds? As analyzed above, the bands come in various categories. For instance, the corporate bonds are issued by companies, the municipal bonds through the local government, the agency bonds issued by government-created bodies, and finally the US government bonds issued by the federal government (Bhojraj & Sengupta 2013). The bonds are traded to the public who purchase them to earn interest upon maturity of the coupons. The parties buying the bonds mainly include the investors. The investors, in this case, can be categorized into many groups of people. Depending on the type of bond, there are various categories of buyers. For instance, the US government bonds are mainly bought by the Social Security, federal government entities, the federal reserves, and foreign governments (Burik & Ennis 2011). Many critics have questioned the US bond that how the government can borrow from itself. Most of these federal bodies operate independently and, therefore, have the capacity to buy the government bonds (Bhojraj & Sengupta 2013). The US government bonds are often considered lucrative due to the tax-exempt nature. They bring good returns to the business owners. In 2014, the social security was been approximated to own 16% of the bonds, the federal government entities followed closely by 13%, and then the Federal Reserve had 12%. The federal governments were also seen to hold a considerable amount of bonds. In the same year, the foreign countries were observed to own 34.4% of the bonds. China had the largest share of 7.2%, followed by Japan 7% (Sender 2009; Sarig & Warga 2010). The municipal bonds, on the other hand, are purchased by the public. The members of the public interested in buying the bonds can apply and make the bond purchases. Such are the investors who seek to earn interest on their capital. The investors, in this case, may decide to have an active portfolio management approach in which the bonds are purchased and then sold instead of waiting for it to mature. The approach further entails the generation of income from capital gains and yields obtained from selling the bonds at premium rates (Chen, Lesmond, & Wei 2007). Why investors may still buy bonds despite negative yields Despite the risk of losing on returns, most investors have been observed to be willing to buy into the negative yields. The investors have a number of reasons for engaging in such risks. The demand for negative yields was witnessed to be on the rise in 2014. The negative yielding bonds resulted in $1.7 trillion in European debt, an indication that investors are willing to take the risk (Sarig & Warga 2010). Various factors have been attributed to this behavior. Some of these include: Currency speculation: most investors often invest into negative yields as they speculate that the currency would appreciate in value that is above the negative yield of the given bond. The investors can then swap their received currencies at the open market to get profits. Expected deflation: investing in the negative has been seen to, bring positive yield. This implies that yields have high buying power compared to the original investments. This may happen in the case of deflation where the inflation rate is above the negative yield placed on the bond (Taylor & Taylor 2004). For instance, if deflation in the United States is expected to be 3 percent, and the bond negative yield stood at 2 percent, then the increased buying power would lead to a positive yield of 2 percent. The expectation of rise in bond prices: most investors own negative yields while anticipating the prices in the global markets to raise. The ECB stimulus in its developing stage has not had sufficient room to make a material impact; there is, therefore, a possibility of bond prices changing. In such a case, the investors would trade the bonds at a profit (Burik & Ennis 2011). Is there an economic theory for buying bonds with negative yields? Yes, there is. One of the theories that has been used to explain the rationale behind purchasing of bonds with negative yields is the theory of purchasing power parity. The purchasing power parity theory estimates the purchasing power of a currency and compares with another in consideration of the exchange rates (Officer 2008). The exchange rate is therefore measured against the $. Believers in the purchasing power parity theory believe that, in the long run, the exchange rates would adjust in response to the price differentials. Countries that have high inflation rates often have depreciating currencies, relatively, the countries with low inflation are likely to observe a rise in the currency value (Ambrose & Warga 2009). Thus, the international investors who anticipated seeing a lasting deflation may also expect the Swiss franc gain a steady rise. Such persons would be willing to buy the government bonds despite the anticipated negative yields (Barro 2007). Through this theory, many investors have engaged in taking various risks and purchasing the bonds with negative yields. Many economists use this theory to predict the market behavior in the event of various happenings such as inflation. Changes in the currency, values between countries have been seen to have great effects on the buyers decisions to purchase the bonds. The bonds play significant roles in the development of companies and country since it utilizes these to carry out their major functions. The buyers of the bonds tend to vary depending on the buyers available. References Ambrose, B. W., & Warga, A. 2009, Pricing effects in Fannie Mae agency bonds. The Journal of Real Estate Finance and Economics, 11(3), 235-249. Asquith, P., Au, A. S., Covert, T., & Pathak, P. A., 2013, The market for borrowing corporate bonds. Journal of Financial Economics, 107(1), 155-182. Bao, J., Pan, J., & Wang, J. 2011, The illiquidity of corporate bonds. The Journal of Finance, 66(3), 911-946. Barro, R. J. 2007, Are government bonds net wealth?. The Journal of Political Economy, 1095-1117. 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