Bonds,Bonds Rating, and Types of Bonds - Essay Example

Bonds and their Ratings Bonds and their Ratings A bond can be defined as a financial instrument that indicates indebtedness of the issuer to the bond holder, the former being obliged to repay the principal plus accumulated interest over a certain period (Maeda, 2009). A bond is therefore a type of debt security. Bonds are usually issued by corporate bodies or the government to investors. Often, they are used by the government to obtain finances for various activities or projects. The bond issuer is required to define the terms or repayment and the interest rates to be paid to the bond holders.

A maturity date is also identified which is basically the principal sum ought to be repaid. Prior to issuance of the bonds, rating has to be carried out and a rating awarded. Bond rating is necessary as it enables the holder to know the ability of the issuer to pay the coupons and principal in a timely manner or as agreed. At the time of issuance, coupon rates (interest rates) as well as other obligations such as maturity date have to be defined and agreed upon by the issuer and the holder. Bonds ratings are carried out majorly by three agencies; Standard & Poor’s (S & P), Fitch Ratings and Moody’s Investors Service (Maeda, 2009).

By analyzing various statistical aspects, letters which indicate ratings are assigned on the bonds. For instance, S & P, Moody’s and Fitch designate bonds as follows. FITCH MOODY’S S & P RATING DESCRIPTION AAA Aaa AAA Extremely strong in making repayments AA+, AA & AA- Aa1, Aa2 & Aa3 AA+, AA & AA- Very strong A+, A & A- A1, A2 & A3 A+, A & A- Strong BBB+, BBB & BBB- Baa1, Baa2 & Baa3 BBB+, BBB & BBB- Adequate BB+, BB & BB- Ba1, Ba2 & Ba3 BB+, BB & BB- Less vulnerable B+, B & B- B1, B2 & B3 B+, B & B- More vulnerable CCC Caa CCC Currently vulnerable CC Ca CC Currently highly-vulnerable C C Currently highly-vulnerable D C D Evidence of failing to pay Above: A table showing various ratings and their descriptions.

There are a variety of bonds available to holders, each with differing term agreements, coupon rates and other characteristics. The following are the various categories of bonds. Treasury bonds These bonds are also known as government bonds. This is because they are bonds issued by the federal government. Treasury bonds are categorized as risk free bonds. They are not exposed to any risks such as call risk and credit risk. Their returns, although minimal compared to other bonds is guaranteed by the federal government (Maeda, 2009).

Municipal bonds These bonds are issued by the local government, state, a city or their respective agencies. A distinguishing characteristic of these bonds is that their returns are tax exempt from the federal government. In addition, they may also be exempted from taxation by the local governments (Maeda, 2009). Zero-coupon bonds A major characteristic of these bonds is that they do not pay interest on a regular basis like other bonds. However, holders are usually given a huge discount par value.

The holder therefore receives a huge bonus at maturity which includes the interest. Convertible bonds These are bonds that can be exchanged for other securities such as shares of stock. This can only be done at the option of the bondholder provided that the shares of stock are issued by the bond issuer. This is an extra feature added by corporations to make debenture bonds less risky in nature. These bonds usually exhibit a stipulated conversion bonds (Maeda, 2009). High-yield bonds These are also known as junk bonds.

These bonds pay a high level of interest although they are categorized as high risk. The rating of these bonds falls below the investment grade. Fixed rate bonds These types of bonds pay a fixed rate of interest throughout the period and before their maturity period. Fixed rate bonds may lose value in case of high inflation rates. Collable bonds These types of bonds can be bought back before maturity date by the issuer, a scenario common some of preferred stocks. Companies are allowed to exercise this right in situations where current interest rates obligations are higher compared to a scenario where it would issue new bonds at a lower interest (Maeda, 2009).

Mortgage bonds The issuer of these bonds pledges property as a guarantee to the bondholder that all payments will be paid. Failure to make the payments, the bondholder has the legal right to acquire the property under the pledge. Subordinate bonds These are bonds that are given lower priority by the issuer in making payments compared to other bonds during liquidation. For example, in case the issuer is declared bankruptcy, some creditors holding senior bonds are paid first (Maeda, 2009). Exchangeable bonds These are a type of bonds that give the bondholder a right to exchange them for stock of another company under certain terms.

In most cases, the issuer may have a stake in the other company or it may be a subsidiary (Maeda, 2009). Reference Maeda, M. (2009). The complete guide to investing in bonds and bond funds: How to earn high rates of return--safely. Ocala, Fla: Atlantic Pub. Group.