Bond (finance) facts for kids
A bond is a contract between two companies. Simply put, a bond is a receipt given by a government or organization as an agreement to borrow money from another organization which will be returned at a later date with certain amount of interest or increment.
Bonds have a maturity date. This means that at some point, the bond issuer has to pay back the money to the investors. They also have to pay the investors a little bit more than they paid for the bond.
Bonds are usually traded through brokers and are part of a financial instrument group called Fixed Income. Banks and financial institutions offer loans on different terms against the security of assets.
The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond:
- Fixed rate bonds have a coupon that remains constant throughout the life of the bond. Other variations include stepped-coupon bonds, whose coupon increases during the life of the bond.
- Floating rate notes (FRNs, floaters) have a variable coupon that is linked to a reference rate of interest, such as Libor or Euribor. For example, the coupon may be defined as three-month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.
- Zero-coupon bonds (zeros) pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).
- High-yield bonds (junk bonds) are bonds that are rated below investment grade by the credit rating agencies. As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield.
- Convertible bonds let a bondholder exchange a bond to a number of shares of the issuer's common stock. These are known as hybrid securities, because they combine equity and debt features.
- Exchangeable bonds allows for exchange to shares of a corporation other than the issuer.
- Inflation-indexed bonds (linkers) (US) or Index-linked bond (UK), in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United Kingdom was the first sovereign issuer to issue inflation linked gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
- Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
- Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBSs), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
- Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
- Covered bonds are backed by cash flows from mortgages or public sector assets. Contrary to asset-backed securities the assets for such bonds remain on the issuers balance sheet.
- Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are virtually perpetuities from a financial point of view, with the current value of principal near zero.
- The Methuselah is a type of bond with a maturity of 50-years or longer. The term is a reference to Methuselah, the oldest person whose age is mentioned in the Hebrew Bible. The issuance in Methuselahs has been increasing in recent years due to demand for longer-dated assets from pension plans, particularly in France and the United Kingdom. Issuance of Methuselahs in the United States has been limited, however, as the U.S. Treasury does not currently issue Treasuries with maturities beyond 30 years, which would serve as a reference level for any corporate issuance.
- Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.
- Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity are sent to the registered owner.
- A government bond, also called Treasury bond, is issued by a national government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the “full faith and credit” of the relevant government. For that reason, for the major OECD countries this type of bond is often referred to as risk-free.
- A supranational bond also known as a "supra" is issued by a supranational organisation like the World Bank. They have a very good credit rating like government bonds.
- exempt from the federal income tax and sometimes from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt. Municipal bonds issued in U.S. territories are exempted from all federal, state, and local taxes, making them triple-exempted. Municipal bonds (or muni bonds) are typical debt obligations, for which the conditions are defined unilaterally by the issuing municipality, but it is a slower process to accumulate the necessary amount. Usually, debt or bond financing will not be used to finance current operating expenditures, the purposes of these amounts are local developments, capital investments, constructions, own contribution to other credits or grants.
- Build America Bonds (BABs) are a form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional US municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the US state where it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds.
- Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.
- Lottery bonds are issued by European and other states. Interest is paid as on a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.
- War bond is a bond issued by a government to fund military operations during wartime. This type of bond has low return rate.
- Serial bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.
- Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse", meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.
- Climate bond is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation- or adaptation-related projects or programmes.
- Dual currency bonds
- Retail bonds are a type of corporate bond mostly designed for ordinary investors. They have become particularly attractive since the London Stock Exchange (LSE) launched an order book for retail bonds.
- Social impact bonds are an agreement for public sector entities to pay back private investors after meeting verified improved social outcome goals that result in public sector savings from innovative social program pilot projects.
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Bond issued by the Dutch East India Company in 1623
Bond (finance) Facts for Kids. Kiddle Encyclopedia.