1. What are bonds and the different types of bonds
As we mentioned, bonds are contractual agreements for borrowing and lending between borrowers and investors. Bonds are a separate funding mechanism an entity can get besides bank loans, although they are contractual as well. For example, a $100 bond paying coupon rate of 5% maturing in 10 years would pay you $5 every year for 10 years, where you then get back your $100.There are many bodies that can issue bonds, mainly government and private companies. Governments issue bonds when they run out of money. How do they run out of money? Well governments get their revenue mainly from taxes, sometimes in a bad economy such as financial crises, entire economy plunges and that is bad on tax revenue. Sometimes they just want to spend more than they have (such as the USA) be it due to badly planned expansions or too much natural disasters. Road repairs, infrastructure upgrading, military spending, building more lamp posts on the roads, reclaiming land ALL requires money which are funded by the government, so sometimes they just need more money than they got, this is what we call a government deficit.
And so they issue government bonds. Treat this as the government borrowing money from it's citizens to build stuffs for the benefit of the citizens, good right? In Singapore, our government is in a surplus, meaning they are actually earning more than they spend. However, as an avenue for citizens to invest their money in a risk-free asset, they still offer bonds that pays you a coupon yearly, but they are so low that you might as well invest them elsewhere. It makes sense because if they don't really need your money, definitely they are not going to pay high interest for it.
Secondly, here are the people who really needs your money. Corporations. Companies issue bonds as a method to raise funds, with the other being equities, but as we shall see there are a plethora of ways to raise funds. We'll go through that in corporate finance.[xx] Why do they raise funds? Most of the time they are probably planning expansions, acquisitions and sometimes to tide them through a bad year. For example, if Singtel wants to build more telephone lines and radio towers, upgrade computers, implement a 5G network etc. all of these requires money. If they do not have enough liquidity, such as cash in the bank, they would have to borrow the money first and to pay them once these investments pay off. It's another matter if they DON'T pay off, though. Therefore, by terms of 'neediness', we can see that companies need the money more than governments, since their profit is at stake, and so they will be willing to pay more on their bond's interest. As a gauge, if SG government bond is 2%, most companies would probably be at 4-5%.
But what if the government is actually in deficit and really needs your money to pay for the defense in case north korea nukes them? Will their coupon rates be as high as a company's? Most of the time, no. We will now discuss another factor affecting bond yields - credit risk.
Credit risk is the risk that a bond defaults, which means that they are unable to either pay the promised coupon rates and/or the face value at maturity. This is what would happen if a planned expansion for a company turns very very sour. Most companies usually operate on a relatively low debt-equity ratio such that in event of a bad decision making, they wouldn't go bankrupt immediately. The optimization of this would be covered in capital structures.[xx] Other than that, remember that a bond usually lasts a long time, commonly more than 5 years. It is hard to tell what will happen to the company in 5 years time. There could be new technology rendering their product useless, a major embezzlement or fraud (see barings bank) or simply bad economic conditions causing the firm to be unable to pay its debts.
Governments on the other hand, have a much more steady stream of income from taxes compared to individual corporations. Governments can also control their spending much more ad-hoc than corporations. Lastly, government CAN print money via the central bank to repay their loans. Therefore the credit default risk of government bonds is extremely low, where in the financial world, they are referred to as risk-free assets. We will take a look at why governments do not print money to solve every financial problems we have later on. [xx]
Given these increased risk from a private company defaulting, an investor would expect a higher return from lending them money. Simply put, risk = return. This would explain why government bonds carry a lesser yield/coupon rate than corporate bonds.
2. Yields of bonds, issuance and secondary market
At the point of bond issuance, the face value (also called par value) is usually fixed at a nice number, say $100. This would allow the coupon rate to be calculated easily and to also facilitate transactions. If a company wants to raise $1million, they would simply issue 10,000 of these $100 bonds. Note that bonds are usually issued via a underwriter who then sells it in smaller chunks in the secondary market. It means that an investment bank will pay the entire $1million themselves less some cut off as commission, and cut them into smaller pieces of $100 or $1000 bonds to sell in the SECONDARY market, because obviously very little investors would have or want to purchase $1million in bonds at one go. Initially, these $100 bonds with a coupon rate of say 5%, would pay you $5 annually till maturity, thus your YIELD TO MATURITY(YTM) is also 5%.However, after the initial issuance, the demand of a certain bond might increase. It might be due to interest rate falling, so that no other bonds have such a high coupon rate anymore or that the safety rating of that issuer has gone up and thus more investors want to buy those bonds. Remember that the company had already raised the money it needs and is NOT issuing any more bonds, so any increased demand for the bonds would have to be fulfilled by the existing secondary market. Increased demand would bid the price of these bonds up. For example, if you buy the same $5 bond at $110, your yield to maturity would fall to approximately ~4.5%. You cannot simply use the 5/110 as the YTM since maturity affects the YTM, thus approximate.
As an investor, what you should be interested in is the YTM, not coupon rate, although that plays a part too. For example, off the bat a bond paying a coupon rate of 6% would be better than a 5% one, but what if the 6% bond costs $150 and the 5% costs $110, which is the better one now? IMPORTANT: Note that in this example, the 6% bond WILL NOT pay you 6% of $150, but 6% of its par value of $100, which is $6.
3. Bond pricing
Note: This section contains technical information not needed by the average person unless you're a student or worker in the finance industry, or you are very keen in learning, then by all means.
YTM can be defined as the yield you are getting per annum if you hold the bond to maturity, given the price you paid for the bond. Without any calculations, one should intuitively tell that if a bond is purchased at a price HIGHER than the par, also known as a premium, the YTM will be lower than the coupon rate, and vice versa. If you buy a $100 par bond at $150, then definitely your yield will be lesser than the coupon rate % on the bond.
The pricing of a bond is simply the net present value of the future cash flows of the bond, and so we consider the net present value formula:
NPV : CF1/(1+r)^1 + CF2/(1+r)^2 + .... CFN/(1+r)^N
NPV : CF1/(1+r)^1 + CF2/(1+r)^2 + .... CFN/(1+r)^N
Where (1+r)^N is the discount factor. For more understanding on discount factor, refer to time value of money. [xx]
CF would be respective cash flows.
In the case of bonds, it would look like:
Bond price: Coupon payment 1/(1+YTM)^1 + coupon payment 2/(1+YTM)^2 + .... last coupon payment/(1+YTM)^M + Par value / (1+YTM)^M
Where M is the maturity periods. If a bond pays annual coupons and mature in 10 years, M is 10. If a bond pays semi-annual coupons(2 times a year) and mature in 10 years, M is 20.
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. WIP TBC
