A bond is a way for companies, countries or states to acquire additional capital. Bonds ensure buyers the repayment of the face value, as well as a fixed interest rate.
What is a bond?
The sale of bonds makes the seller the debtor. The buyer becomes a creditor. This has a claim against the debtor . This is evidenced in the bond. The bond consists of two parts: the coat and the bow. In the coat the demands of the creditor against the debtor are evidenced. The bow is composed of coupons. The coupons include interest and other income claims.
As the interest rate remains constant throughout the term, bonds or fixed income securities are other names for bonds .
In particular, the bond gives the creditor the legal right to a repayment equal to the face value and a percentage interest rate on the bond according to the amount of the coupons. The debtor pays the interest every six or twelve months at fixed dates. In addition, in the event of insolvency, creditors have the legal right to priority over shareholders in respect of repayments. In a bankruptcy so get the creditors first, the repayments.
The borrower or issuer has the advantage of a loan that he avoids a loan from a financial institution. He receives capital without having to provide collateral .
When the bond expires, the creditor gets his investment back. This is, unlike equities, not as an amount in a currency, but set as a percentage .
In addition to the standard bond described, there are other forms available. These include the zero coupon bond or the zero bond . Another form is the amortization loan or amortization loan . Annuity bonds offer constant amounts during repayment. The floater bond, the step-up coupon bond and the inflation-linked bond are three more examples. The last two forms of bonds are perpetuals such as government bonds and tiered bonds such as the Federal Treasury .
What conditions apply to bonds?
The loan terms are included in the documents that the debtor issues to the creditor. These determine which obligations the debtor has the creditor and which rights the creditor has .
A particularly important point is that the debtor regularly provides the creditor with information about all important changes and innovations to the bond . These include the remaining term, repayments, distribution dates and the issue volume .
Other important information is the currency, the amount of the minimum investment, denominations, information about what the borrower uses the capital for, tax and rating grades.
Significant portions of the information that protect investors are collateral, termination and other safeguard clauses, as well as legal information on the Debt Securities Act.
The investor is dependent on the creditworthiness of the debtor for an unsecured bond. If the debtor is insolvent, the investor has no chance of getting his money. A secured bond gives the investor additional protection . The bond is linked to collateral that compensates for financial losses in the event of insolvency. The type of security depends on the bonds. The debtor has many options to give collateral. The collateral is administered not by the debtor himself, but by an independent trustee. Common forms of collateral are associated with real estate. These include mortgages and land charges . Other securities are letters of comfort and guarantees . Investors are given the opportunity to receive their capital by having non-cash debtors sell inventory and other movable assets.
The term of a bond is selected by the borrower in accordance with current interest rate developments. Low interest rates enable long-term and cost-effective financing of the company . Usual maturities last less than four, less than eight or more than eight years. The borrower designs maturities so that he efficiently invests in his company and repays the money only when the company is financially secure.
Classes of securities
In addition to companies, states need a sufficient amount of capital. The state finances its budget or individual projects. In order for enough capital to be available, the government uses bonds in the same way as companies. Government bonds in Germany concern the federal government, the states, the municipalities and state special assets such as equalization funds and the assets of the German railway .
Currently, the German government offers bonds in the form of six different types of securities .
- Funding Treasures of the Federal Government
- Federal Treasury notes
- Non-interest bearing Treasury Notes
- Federal bonds and Federal Treasury notes.
Companies also use bonds to finance themselves in the medium term. Above all, newly founded companies have few collateral to offer. Credit institutions grant loans depending on collateral . If a company has no collateral, it either receives no credit or a loan on barely portable terms. Corporate bonds are the only way for many companies to finance themselves. Since borrowers depend on sufficient credit to get their money back, the details of the bonds depend on it. Underperforming companies offer high yield and unfavorable interest rate bonds.
Pfandbriefe are another form of bond. They have as security real estate or movable valuables of high value , such as ships. Since Pfandbriefe are always associated with a pledge or a seizable item, they are considered particularly secure. This is conditional. Real estate and movable valuables secure a theoretical security for the debtor. Whether he recovers his assets from this security depends on the market. If there is no buyer for the pledge, this security is similarly worthless as a bond without security.
Forms of the bond
The standard bond is the best known form. This is the described basic form. In addition to this, there are other forms available. An example is the zero coupon bond . Here there are no interest coupons, so that the creditor earns exclusively on the price gain. The Perpetuals are bonds with no maturity limit. The creditor earns exclusively on the interest. An example of this is the government bonds in particular. Furthermore, repayment bonds are part of the repayment is not complete and not directly after maturity. Another form is the annuity bond. Here the repayment is made at the end of the term in equal amounts. With the floater bond , the debtors can adjust the interest rate variably. In addition, the tiered bond is another form. This is a bond whose interest rate increases gradually. An example of this is the Federal Treasury letter . In addition, step-up coupon bonds are available. Here, the borrower adjusts the interest rate to the credit rating, according to the ratings of rating agencies. As collateral for creditors, the debtor adjusts the face value of inflation-linked bonds.
As with other forms of investment, there are various risks associated with bonds. These depend on various factors and have different influences on the bonds .
The most important risk is the default risk or credit risk . The default risk denotes the possibility of a temporary or complete insolvency of the debtor. Various rating agencies rate companies and states and create a rating. A worse rating signals a higher default risk . To compensate for the high level of risk, borrowers offer investors high coupon interest, which is considered a risk premium.
The interest rate risk depends on the market interest rates . Bonds are subject to fluctuating rates. These depend on the market interest rate. At maturity, the borrower pays the full face value of the bond to creditors. It happens that a creditor sells his bond himself before the end of the term is reached. If the market rate rises at this time, the nominal value of the bond falls below 100% and the investor makes losses. Low-interest, high-yield bonds are therefore better.
The risk of termination offers borrowers the opportunity to pay bonds before the end of their regular term. If the debtor uses the right of termination, the creditor gets his investment back to full face value . In this case, the investor escapes interest, which may have been fixed. This results in a lower profit for the investor. The debtor then has the opportunity to sell new bonds. These have a different interest rate, which is more favorable for the debtor.
For bonds denominated in another currency, not the euro, there is a currency or exchange rate risk. This concerns foreign bonds. If the currency of the bond weakens than the euro, an investor makes losses, even though he receives the entire face value.
Inflation risk concerns the actual amount of interest payments . The result is the real return, which corresponds to the return paid less an inflation rate. Some countries offer inflation-linked bonds that reduce this risk. The liquidity risk concerns the case of the premature sale of bonds. If the creditor does not find a suitable buyer, he is forced to sell his bonds at bad rates.
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