After this session you should be able to understand the various features of a bond and know what the relevant market conventions are for the trading and settlement of bonds and money market securities.
There are five main features of a bond that will be examined in this session:
- issuer
- maturity
- coupon
- face value
- call options
Conventions for trading and settlement will also be discussed.
Issuer
The issuer is the government body, corporation or special purpose vehicle that is actually raising debt and therefore borrowing money by issuing the bond. It is this entity that is making the promise to repay the debt (in some cases the repayment may be guaranteed by another entity).
It is important to understand exactly which entity (legal vehicle) is issuing the bond (and the nature of the guarantee, if any) because ultimately it is they who are promising to repay the bond at maturity and make the regular interest payments associated with the particular issue.
Sometimes there may be a parent company involved in the structure. If that is the case, it is important to understand the nature of the relationship between the issuer and the parent company. It is also essential to understand whether or not there is a guarantee in place from the parent company. If there is no guarantee the investor needs to make an assessment of the willingness of the parent to support its subsidiary that has issued the bond.
Maturity
The maturity is the date on which the issuer promises to repay the face value of the bond and to make the final interest payment. One of the defining features of bonds is that they generally mature on a specific date.
Other fixed income securities, for example perpetual income securities, do not have fixed maturity dates. These securities are discussed in Session 10.
Face value
The face value of a bond represents the principal amount that needs to be repaid by the issuer on the maturity date. Bonds are usually priced assuming a face value of $100. If the bond is pre-payable, then the face value, less pre-payments, will be the amount paid to the investor.
Coupon
Coupons are the periodical interest payments that an investor receives on a bond. The term coupon is derived from the old bearer certificates where, when an investor purchased a bond they actually received a certificate with the coupons attached to the bottom of them. Each time an interest payment was due the investor literally tore off a coupon and physically presented it to receive their interest.
The coupon rate may or may not represent the actual return the investor receives from the bond and this is determined by the purchase price of the bond. The purchase price of a bond can be at par ($100), at a discount to face value (less than $100), or at a premium to face value (more than $100). So, depending on the purchase price of the bond, the actual return to the investor may be higher or lower than the coupon rate. This measure of return is known as yield to maturity.