BONDS play a vital role in the world economy – both for governments and companies who wish to borrow money, and for investors as an alternative to bank deposits and as a means of diversity and risk reduction in investment portfolios.
A bond is a debt security in which an issuer, usually a government or company, borrows money from an investor for a defined period of time and at a fixed rate of interest. Governments issue bonds as means of financing budget deficits and to fund programmes and projects. Corporations may issue bonds to finance business expansion, acquisitions or enter new markets.
Debt financing is an alternative to equity financing – once the company repays the borrowed money it no longer has an obligation to the investor.
There are certain fundamental features of a bond. The par value, also called the nominal amount, refers to the amount that is repaid to the bondholder when the security matures. Bonds are typically issued at par value. Corporate bonds normally have a par value of 1,000. The maturity date is the date in the future which the issuer promises to pay the investor’s principal.
Bonds can be issued for as little as one day, but are normally issued in tenors of 5, 10, or 30 years. Tenor, or term, of a bond, is the length of time until maturity of the bond.
The coupon is the interest rate the issuer agrees to pay the investor.
A bond with a fixed rate pays a constant coupon that does not change for the term of the bond. A variable rate coupon is based on a certain indicator such as a market rate, and will change periodically with the movement of that rate. Coupons are normally paid every six months. The rate of interest a bond will pay is based on the present market rate, the term, and the credit quality of the issuer.
Credit rating agencies assess the creditworthiness of most major issuers and provide investors with an indication of the issuer’s capacity to repay. As a bond is a promise to repay the holder, an investor is subject to default risk, the risk the borrower fails to repay.
The yield on a bond is represented by the percentage of interest to be paid by the issuer on the par value of the bond. Thus if the bond has a coupon of $70 per annum on a par value of 1,000, the yield is 7 percent.
The market price of a bond will fluctuate once the bond is issued and traded in the secondary market, primarily based on the underlying
market interest rates and changes in the issuer’s creditworthiness.
Bonds trading below par are said to be traded at a discount, if above par, at a premium. The current yield of a bond represents the percentage return based on the current price, thus the annual coupon divided by the market value.
If our same bond is trading at a value of 900, then the current yield is 7.78 percent (70/900). Thus the yield and price of a bond are inversely related so that when market interests rates rise, bond prices fall, and vice versa.
As new security instruments are introduced to the Cambodian market later in the year, investors will have alternatives to bank deposits and real estate. Bonds are likely to gain attention given they are usually considered less risky than equities.
Anthony Galliano is Chief Executive Officer at Cambodian Investment Management.