Bonds

Debt Instruments

Bonds, commercial paper, medium-term notes and certificates of deposits are of the same broad legal nature and format. There is a certificate or document of title by which the issuer or debtor promises to pay the bearer specified amounts of money on a specified date.

A bond, when used in the context of securities, is effectively a transferable loan. Some bonds may be tradable by delivery. Bonds historically, are bearer negotiable instruments.

They were commonly issued in negotiable form rather than registered form. In modern times, they are issued electronically, with the records held through books of agents and clearing systems. Although their rights are intangible rights enforced through court action, the negotiable instrument gives them some characteristics of tangible property.

Bonds are the principal instrument traded in euro markets. Other debt instruments include commercial paper, certificates of deposit and medium-term notes.

Issue of Bonds

In some respects, bonds are similar to shares. Bonds are issued by companies on a subject to similar registration to share. Bonds, shares and other equivalent instruments are commonly referred to as securities. Other commercial loan/credit instruments include commercial paper, medium-term notes, certificates of deposits

Companies may issue bonds sequentially. Registers of bondholders, either in material or dematerialized form, will be kept.  Bonds are transferable with registration through the materialized register or dematerialized electronic register.

In contrast to a company share, a bond is debt rather than capital. It is repayable in the same manner as a loan. Bonds may be secured or asset-backed. A covered bond is one from which the repayments are guaranteed for a particular pool of assets.

There may be an associated trust for the benefit of bondholders. There will be covenants equivalent to bank loan covenants. Interest on bonds will be usually deductible, as with older debt. In contrast, a share is capital. It is not a loan, and payments on it are taxable as dividends.

Bonds may be issued by corporate entities or by governmental or sub-governmental authorities. In Ireland, bonds commonly encountered are those issued by state, local governments or semi-state authorities.

Bondholders

A bond is, in some senses, like a syndicated loan. There are numerous lenders, lending and having rights under common documents.

The bond documentation is analogous to a loan agreement. The bond trustee is akin to the lead lender in a syndicated lending facility. The trustee under bond documentation owes fiduciary duties, and they, for example, hold security. He represents the interests of the investor/lender.

The holder of a bond is a creditor. The terms of the bond determine his or her rights. The entitlement is generally to cash by way of fixed interests throughout the life of the bond and capital repayment at the end.

There may be an entitlement to capital repayment only with no interest. In this case, this is reflected in the current price of the bond, which is discounted to represent the implied interest rate.

Interest

Generally, bonds are fixed-interest obligations. Variable-interest bonds exist but are less common.

Where general interest rates rise relative to the bond interest rate, financial arbitrage tends to cause the bond price to fall so that the nominal interest relative to the value equates to the competing interest rate. Conversely, when interest rates fall relative to the bond interest rate, the bond price will increase above its nominal or par value in line with competing interest rates.

The effect of the differential of the bond interest rate relative to competing interest rates or other investments will tend to diminish as the bond reaches repayment. Ignoring the credit risk and ability of the issuer to pay, the bond price will tend to converge towards its nominal value as the date for repayment or redemption approaches.

Issuer Creditworthiness

Bonds are usually issued on an unsecured basis. Within the last 20 years asset backed bonds or securitized bonds are more common and are backed by the stated assets.
The issuer of the bond is the borrower. It is commonly a sovereign entity local authority or state Corporation. Bonds may also be issued by high-value companies or their subsidiaries with a parent guarantee.

Securitized vehicles may be unowned or so-called orphaned SPVs. Historically non-sovereign issuers were large companies and household names.

In practice, only sovereign, quasi-sovereign entities and well-capitalized and established companies issue bonds. Effectively, the issue of bonds cuts out the intermediary financial institution for a bond issuer with a strong credit rating.

Risk and Rating Agencies

Credit rating agencies play an important role in the bond market. There are a number of international credit rating agencies, which are private bodies rating bonds in accordance with their credit risk.

Rating agents are independent of the bond issuers but are paid by them. Rating agencies have been subject to severe criticism in relation to bond ratings, which proved in the financial crises to have been, at best, unduly favourable and, at worst, misleading in some cases.

Commercial Terms

Bonds in the European bond markets were most commonly issued in dollars. Euro and other currencies, Canadian dollars, sterling and yen issues are also prominent.

Maturities are typically five to seven years but may be as little as one year. The lower term bond is referred to as notes, while the upper end is referred to as bonds. Floating-rate note-rated instruments are commonly referred to as floating-rate notes irrespective of maturity.

Investors will expect that payments on bonds are not subject to withholding tax or deduction in the domestic country. If it is so, then the issuer may agree to gross up payment so that the investors receive the net amount as if no tax had been deducted. In the case of other types of securities, such as asset-backed issues, the risk of withholding tax may lie with the investor.

Guaranteed bonds may arise in the context of securitized issues or special-purpose vehicle subsidiaries. They enhance the credit standing of the issuer. There are specialist guaranteed institutions and mainline insurance companies which provide guarantees.

Securities Market

Bonds are securities and are subject to the same broad regulation as shares. Bonds may be admitted to the official list of a stock exchange. They are subject to the same prospectus transparency and disclosure rules.

As with shares, bonds have a secondary market. Depending on the terms of the bond, the price of the bond in the secondary market will usually be a discount to the capital sum repayable, reflecting a discount of the future interest and capital payments together with credit risk factors and factors related to interest rate.