Banking and Finance - Different Types of Bonds - Essay Example

?Banking and Finance Affiliation with more information about affiliation, research grants, conflict of interest and how to contact Banking and Finance Bond is a debt instrument through which the individual gives loans to companies as well as the government for specific period of time. During this period, the investors get a fixed percentage of interest on their investment. The period and the percentage of interest changes according to the nature and kind of bond. Bonds provide fixed income to the investors and it is a safer investment choice, therefore, bonds are called fixed income bearing securities. Interest on the bond is provided every six months and the principle amount is given at the maturity date. Generally, bonds are issued by the corporation and government bonds are differentiated according to the payment of interest, the market they are issued in, the currency they are to be paid in and the legal status etc. Corporate bonds can be purchased through the security market. Company bonds provide high rate of interest but have more risks as compared to the government bond. While selecting the bond, the risk tolerance of the investor should be taken into consideration. Those who are ready to bear risks, can invest in corporate bonds and those who cannot afford any risks, can choose the government bond. “ The credit risk associated with bonds range from relatively safe Treasury bills to extremely risky junk bonds to corporations or countries that are in a questionable financial position” (What are the Different Types of Bonds Available?, 2009, para. 4). The various kinds of bonds are as follows: Zero Coupon Bonds: The zero coupon bonds are those which became famous recently Zero coupon bonds are those bonds on which the companies do not provide the interest but issue the bonds at a discount rate with comparison to the maturity value. The difference between the issue price and the maturity value represent the return or interest. This can be explained through the following example: Suppose the company issues bonds at a value of $200 for each bond during a period of 5 years. Under zero bonds, the investor would not get interest on his investment but at the end of the particular period he will get $220 for each bond. It would then constitute the gain or interest on his investment. As per this, The issue price of bond = $200 Maturity value of bond = $220 Here $20 represents the gain or interest of investment Fixed Income Bonds: Fixed bond is a long term debt paper in which the rate of interest is fixed in advance. Under fixed income bonds, the investor would get a fixed and constant return on his investment at a regular interval and at the time of maturity, he will get the principle amount. Fixed income bonds provide safety to the investor on his investment, so these are preferable to those investors who would like to get stable return on their investment. Mostly state and central government issue this kind of bonds and these bonds are treated as a high safety investment. “The central or national governments also have the power to print money to pay their debts, as they control the money supply and currency of their countries” (Government Bonds, n.d., para. 2). Example: Consider an investor who makes investment on 12% bonds having a face value of $ 150. Suppose he invested on 100 bonds. The investor would get interest rate as given below: Investor makes investment = 100*$150 = $15000 The rate of interest is 12% Return = 15000 * 12 /100 = $1800 Floating rate bonds: In case of floating rate bonds, the interest provided to the investors during their investment is not predetermined. Interests on such bonds are paid in fluctuating basis, from time to time, according to the benchmark price. Under such bonds, the interest rate is determined in accordance with the market interest rate along with some other external factors. “The amounts of these variable payments are determined by the current market interest rates such as the LIBOR (London Interbank Offered Rate) or Federal Funds Rate (FFR) + a spread” (Types of Bonds- Fixed Rate Bonds, Floating Rate Bonds, Asset-Backed Bonds, Perpetual Bonds, Bearer Bonds, n.d.). As it does not provide stable return, investment on these bonds is not a better option for those investors who like to get fixed return on their investment. Investment in floating bonds is different when compared to fixed interest bonds. Interest on this kind of bonds is determined by the market conditions, as interest fluctuates according to market conditions. Floating bonds do not provide a constant return, so investment in these bonds is preferable to such investors who are ready to bear the risk. High Yield Bonds: High yield bond refers to the bonds that pay out higher coupons than usual. They have a huge probability of defaulting on these coupon expenditures. They are consequently graded lower than the investment grade bond. These kinds of bonds are also identified as junk bonds. “The successful high yield bond manager must be prepared to intervene early and forcefully in a deteriorating situation” (Fabozzi, 1997, p. 99). A high yield bond works mostly like other bonds. A depositor purchases a bond from a bond issuer with the statement that the cash will be salaried back when the bond arrives at its maturity date. The variation among a "junk" bond and an "investment grade" bond is that the issuer of the former is incapable of paying back the original principal. For example, a person had a $1,000 bond that remunerated 5% interest. The issuer's credit value state has gradually worsened and currently it is in junk-bond grade. The person needs the bond before maturity, therefore, a dealer proposes $500 for the bond. The bond's yield is interest expense divided by cost that would rise to 10%. This makes it very easy to understand why they describe high-yield bonds as ‘junk bonds.’ Thus, according to this year, junk money has fallen to an average of 2.3%. Asset Backed Bonds: Asset backed bonds refer to the bonds obtainable by the money owing market that is backed up by a varied group of illiquid assets. For instance, credit card debt and accounts receivable collections are comparatively safe savings. If an issuing business defaults on its bondholders, bond debt repayments are then lawfully due to cash flows created from these illiquid groups of assets such as A/R, credit card debt, mortgages etc. “For example, provide some insight into the development of the asset-backed securities market. Before the development of the mortgage-backed securities market in the early 1980s, each residential mortgage underwritten was a unique transaction” (Asset-Backed Securities, n.d., para. 2). Corporate Bonds: Corporate bond means the bond issued by a company. It is a bond that a business issues to increase cash in order to expand its business. The word is regularly applied to long term debt tools, usually with a minimum maturity date, like a year after their issue date. The term "corporate bonds" is inured to comprise all bonds except those started by governments using their personal money. The bonds of supranational organizations and local authorities do not seem much suitable in either group. “The holder of a corporate bond has a legal right to prompt payment of contractually agreed interest payments and repayments on the bond” (Broyles, 2003, p. 43). Corporate bonds are included on main exchanges and Electronic Communications Networks (ECNs) similar to MarketAxess, Bonds.com and the coupon is regularly taxable. Now and then, this coupon can be zero with a top redemption price. Though, in spite of being included on exchanges, the huge majority of dealing volume in corporate bonds in the major developed markets obtains place in dealer-based, decentralized as well as over-the-counter markets. The corporate bond contains a face value, coupon rate and bond term, or virtual years for maturity. For example, the corporate bond has a coupon rate of 5% and the face value is $1,000. It is also seen that the bond disburses out interest once a year and, therefore, the yearly coupon expense is $1,000 X 5% = $50. The Market interest rate is 3%. The cost of the corporate bond is the amount of the bond's future price. The yearly interest expenses and the bond principal go back at maturity and it is low-priced at the market interest rate. Following are the calculations: 50/ (1 + 3%) + (50 + 1000)/ (1 + 3%) (1 + 3%) = 50/1.03 + 1050/1.03 X 1.03 = 48.54 + 1049.99 = $1098.53. So, a corporate bond is $1,000 in face value with 5 % coupon rate and the market value is $1098.53 when the market interest rate is 3%. Municipal Bonds: A municipal bond is a bond introduced by a city or further local government or their organizations. Possible issuers of municipal bonds are various counties, cities, redevelopment organizations, school districts, special-purpose districts, public utility districts, seaports and publicly owned airports and other governmental entity under the stage of a state. Municipal bonds can be common commitments of the issuer or even be protected by particular incomes. “Bond emission brings more visibility to Municipalities and renders better organization with management that is more dynamic, transparent and efficient, those consequently encourage public and private partnerships as well as project financing destined for large scale investments, for example: the construction of large hospitals, universities, airports, access roads, renewable energy parks, central electric installations and others” (Municipal Bond Emission at the Cape Verde Stock Exchange, 2011, para. 3). In the US, interest income is established by holders of municipal bonds and is frequently excused from the income tax of the state as well as from the federal income tax wherein they are issued. However, municipal bonds issued for convinced purposes cannot be excused from taxes. Municipal bonds give tax exception from federal, local and state taxes, depending on the rules of all states. A municipal security contains of both short-term and long-term issues. Short-term issues are utilized by an issuer to increase money for different causes until future incomes are received. For instance, taxes involving federal or state aid expenses, upcoming bond issuances, covering uneven cash flows, meeting unexpected shortfalls and increasing instant capital for projects in anticipation of long-term financing can be agreed. More bonds are regularly sold to finance capital schemes that relate to long term issues. The two essential kinds of municipal bonds are revenue bonds and general obligation bonds. Majority of municipal bonds are issued in smallest values amounting $5,000. For example, municipal bonds valued at 80 a year before, but now are valued for 100 with a 5 % coupon and valued for valued 20 (15+5) points. The sum return is 20/80 or 25 %. The taxable bond is 8 % and the municipal rate is 7 %. If the tax rate is 25 %, the price at which a municipal bond is equal to a taxable bond is (8 x .75) 6 %. Decide the municipal bond and increase 1 % or 12.5 % more yield. Affect of Changes in Interest Rate: Investors in bonds get specified percentage of interest on their investment. Investment primarily depends on the rate of interest that the investor would get from the investment, like in the case of a long term investor, who is not much bothered about the interest and who holds the bond until its maturity date. But short term investor has to consider the interest rate as it affect the bond price. Changes in interest rate would not influence bonds much as it would become matured within one or two years. The changes in interest rate would badly affect those bonds, which have long time to mature, since it would have a large value change. The value of bonds is mainly determined by the interest rate. The bond value and interest rate are inversely related. In other words, when the interest rate increases the value of bond decreases and vice versa. Example: Suppose a bond of $1000 is issued for a period of five years at 5 % interest paid annually. If interest rate is increased by 6%, the investors cannot sell the bond, and at the same time, the value of bond will decrease. From this example, we can understand the affect of bond value by considering changes in interest rate. These changes prove to be risky for investing in the bond as they lead to changes in the value of bonds. When there is a decline in the financial position of the company, the bond value also declines with an assumption that company has become bankrupt. This is a big challenge faced in case of investing in corporate bond. On the other hand, the government bonds give security to the investor as they are risk free bonds. Therefore, the investors who are not ready to take risks better choose government bonds. Reference List Asset-Backed Securities, (n.d.). The Financial Pipeline.com. Retrieved Sep. 29, 2011, from http://www.finpipe.com/assback.htm Broyles, J. E. (2003). Financial Management and Real Options. John Wiley & Sons Ltd. Retrieved Sep. 29, 2011, from http://books.google.co.in/books?id=DJGsyx1bCa4C&pg=PA43&dq=importance+of+Corporate+bonds&hl=en&ei=W7CCTpLFO4ftrQe1tuirDg&sa=X&oi=book_result&ct=result&resnum=7&ved=0CFYQ6AEwBjgU#v=onepage&q=importance%20of%20Corporate%20bonds&f=false Fabozzi, F. J. (1997). Selected Topics in Bond Portfolio Management. Frank. J. Fabozzi Associates. U.S.A. Retrieved Sep. 29, 2011, from http://books.google.co.in/books?id=mnnfw9muEzAC&pg=PA100&dq=importance+of+High+Yield+Bonds&hl=en&ei=ebWCTvGXLofJrAe0lIGMDg&sa=X&oi=book_result&ct=result&resnum=1&ved=0CDQQ6AEwADgK#v=onepage&q=importance%20of%20High%20Yield%20Bonds&f=false Government Bonds, (n.d.). The Financial Pipeline.com. Retrieved Sep. 29, 2011, from http://www.finpipe.com/index.html Municipal Bond Emission at the Cape Verde Stock Exchange, (2011). Bolsa de Valores de Cabo Verde. Retrieved Sep. 28, 2011, from http://www.bvc.cv/index.php?option=com_content&view=article&id=113&Itemi d=127&lang=en Types of Bonds- Fixed Rate Bonds, Floating Rate Bonds, Asset-Backed Bonds, Perpetual Bonds, Bearer Bonds, (n.d.). Finance Scholar.com. Retrieved Sep. 29, 2011, from http://www.financescholar.com/types-of-bonds.html What are the Different Types of Bonds Available?, (2009). Fuze Digital Solutions. Retrieved Sep. 28, 2011, from http://www.fuzeqna.com/ccul/consumer/kbdetail.asp?kbid=115 Read More