A debt instrument is generally issued for a longer tenure i.e. for more than one year. These instruments are issued with the purpose of raising tier-II capital by borrowing. The Federal governments, states governments, municipal corporations, corporate, financial institutions and many other types of institutions sell bonds. Generally, these bonds carry a fixed rate of interest usually known as coupon and are issued for a fixed tenure with defined date of maturity. A bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). There are zero coupon bonds available which promise to pay a fixed sum on maturity.
The investor of these bonds steps into the shoes of a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. On the other hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress like any other creditor.
Various types of bonds are issued. They can be categorized as under:
- Tax Free Bonds or Taxable Bonds.
- Zero Coupon or Fixed Coupon Bonds.
- Secured or Unsecured Bonds.
- Rated or Unrated Bonds.
U.S. Treasury bonds are generally considered the safest unsecured bonds, since the possibility of the Treasury defaulting on payments is almost zero.
The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (in case of a cumulative bond). In case of Deep discounted bonds the only yield will be capital gains.
Market price of these bonds is determined with yield to maturity (YTM). The YTM of a bond depends upon the prevailing interest rates and the credit quality of the instrument. A bond with low credit rating has to provide a higher payout to compensate for that additional risk. |
