Bonds and Their Different Types - Essay Example

CORPORATE FINANCE TABLE OF CONTENT PAGES Introduction 03 An Overview of Bonds 03 Treasury Bonds 04 Corporate Bonds 05 Municipal Bonds 05 Foreign Bonds 05 Zero-Coupon Bond 06 Convertible Bond 06 Income Bond 07 Mortgage Bond 07 Debentures 07 Subordinate Debenture 07 Development Bonds 08 Interest Rate on Bonds and Bonds Values 08 Yield to maturity 11 Conclusion 13 Reference 14 INTRODUCTION: This paper is all about bonds and their different types. The paper elaborates regarding the importance of bonds. Its also include the value and confines of the issuance of bonds. Study shows how interest rates influence the rates of return on bond to condense or hike. The consideration of more and less risk ness also dependent on the fluctuation of the interest rates. Paper shows how the issuances of the bonds are creating values either for the entity and for the bond holders is well. Corporations issue bonds in order to raise their equity and finance things more pertinently. Let's have a glance over the definition of Bonds and their importance and usage. AN OVERVIEW OF BONDS: A debt security in which the issuer is liable to pay interest at a later date to the security holder, which termed as maturity is called bonds. More precisely we can say that a bond is a type of a loan in which the person which issues the bonds is termed as borrower and by contrast a person which holds it, termed as lender. Interest or coupon rate is the thing which becomes a bridge between the borrower and lender which ultimately constrains the value of return, and it must be repaid at fixed interval over a specified period of time. A little bit contradiction found between the bonds and stocks. In general, both are securities but stock holders are the equity stake holder of the company and known as the real owner of the entity, while the bond holders are the lenders to the issuer, which usually have a specified term of maturity after which the bond security gets redeemed (Vernimmen, 2006). According to the statistics of the Federal Reserves (FED), there are more than $1.7 trillion municipal securities, $3.6 trillion of outstanding US Treasury securities, $2.7 trillion of corporate bonds and more than $470 billion of bonds issued by the foreign governments and corporations in the United States. There are several types of bonds a corporation issues. TREASURY BONDS: Usually treasury bonds are referred as the government bonds, which are issued by the US federal government. The bonds are free from default risk because the federal government will make payments on the promised time period. Now, we are well aware with the fact that the treasury bonds have no default risk but that's not mean that such bonds are totally free from risk because the price of the bonds may increase or declines with the fluctuations in the interest rates (Vernimmen, 2006). Treasury bonds are termed as the safest bonds, because the collateral of these bonds are in the hands of the government, which attracts the confidence of the investors and become a triumph for both the corporations and the bond holders. CORPORATE BONDS: We can get an idea in an instant from the name of the corporation bonds that the bonds which are issue by the corporations in order to raise the overall equity of the firm are called corporation bonds. As compared to the treasury bonds, corporation bonds have the default risk appetite in it. It means from any contingency, if the firm envisaged a bad time on the financial health then probably the firm is unable to facilitate its bond holders or we can say that unable to meet or fulfill their financial promises and legal obligations (Cinnamon, 2006). Level of default risk varies with the characteristics of the corporate bonds, which often refereed as "credit risk". MUNICIPAL BONDS: Municipal bonds are also issued by the local government. Its also have default risk like the corporation bonds. However, the interest rate assign with these bonds are relatively below as compared to other bonds but the main instinct it has is that, most of the municipal bonds is exempt from the federal taxes and state taxes, if and only if the bond holder is a resident of the issuing state. FOREIGN BONDS: The bonds which issues by the foreign corporation or foreign government is known as the foreign bonds. Severe default risk associated with such bonds. Let say if a US investor purchases a corporate bond denominated in British Pound and the pound falls relative to the dollar, then ultimately investor will lose money because the currency value gets deteriorate (Vernimmen, 2006). ZERO COUPON BONDS: The bond which doesn't pay any periodic interest rate to the investors is called zero coupon bonds. Zero Coupon bonds also called a discount bond or deep discount bond. In this type of bonds investors earns return from the compounded interest (Cinnamon, 2006). Let say an investor buy such a bond today for $558, and upbeat receives $1000 in ten years. The ten year increase from the original price to the $1000 repayment equals a 6 percent annual return, but with respect to the nature of the bond, it doesn't intend to pay any annual cash interest payment on the investment and the corporation comes up with the full payment of $1000 in ten years for the investor. CONVERTIBLE BONDS: A bond which usually has a maturity period of more than 10 years, and has the characteristics to be convert into shares of stocks or cash of equal value at some pre-announced ratio. The coupon or interest rate is relatively below as compared to the other issued bonds but the investors being compensated with the instinct of conversion into the common stocks. Convertible bonds are issued with the intentions to raise the market capitalization of the corporation. INCOME BONDS: A type of debt, in which the issuer is promised to pay only the face value of the bond to the lender or bond holder. The income bonds have only paid if the corporation has enough earnings to facilitate their debt holders through paying the coupon payment. In other words we can say that the income bonds elaborate the solvency of the corporation. Income bonds are the best tool to assist a corporation to avoid bankruptcy during the bad financial times for the firm. MORTGAGE BONDS: Mortgage bonds are termed as the safest bonds as compared to other bonds. It can be quantify as a bond secured by a mortgage of one or more than one asset which may be liquidate at the time of compensation of default (Cinnamon, 2006). Factually, the mortgage bond offers the investor a great deal of protection with respect to their moneys, that's why a large number of investors have the inclination to invest in mortgage bonds. DEBENTURES: A debenture is an unsecured bond, because it doesn't provide lien against specific property as security for the obligations. A debenture is long-term debt negotiable instrument used by the corporations as well as the government to obtain funds. It commits an entity to pay interest and repay capital to its debt or bind holders. SUBORDINATE DEBENTURES: We are well cognizant with the fact that the term, subordinate means below or inferior to. As far as the subordinates debentures are concerned, then we can say that in the bankruptcy, subordinate debenture holders are the 2nd most investors which are paid after facilitated the senior debt holders (Vernimmen, 2006). Until and unless the senior debt holders is been paid off, the subordinate debenture holders can't be facilitated. DEVELOPMENT BONDS: Development bonds have been issued by the local government. The main prospective of development bonds are to finance the renovation or improvement of public facilities. Development bonds are also comes in the category of tax holiday, as there is no federal or state tax applicable on such bond. INTEREST RATES ON BONDS AND BONDS VALUES: Let's consider Micro Drive Inc, as our company which intends to issue these three types of bonds with different interest rates. (1) Municipal Bonds. (2) Convertible Bonds. (3) Corporation Bonds Municipal Bonds: Let's suppose the following data. Years to Maturity: 10 Coupon rate: 5% Annual Pmt: $100 Par value = FV: $1,000 Going rate, r: 10% Value of Bond in Given Year: N 5% 0 $1,519 1 $1,495 2 $1,470 3 $1,443 4 $1,415 5 $1,386 6 $1,355 7 $1,323 8 $1,289 9 $1,254 10 $1,216 CONVERTIBLE BONDS: Let's suppose the following data. Years to Maturity: 10 Coupon rate: 10% Annual Pmt: $100 Par value = FV: $1,000 Going rate, r: 10% Value of Bond in Given Year: N 10% 0 $1,000 1 $1,000 2 $1,000 3 $1,000 4 $1,000 5 $1,000 6 $1,000 7 $1,000 8 $1,000 9 $1,000 10 $1,000 CORPORATION BOND: Let's suppose the following data. Years to Maturity: 10 Coupon rate: 15% Annual Pmt: $100 Par value = FV: $1,000 Going rate, r: 10% Value of Bond in Given Year: N 15% 0 $708 1 $714 2 $721 3 $729 4 $738 5 $749 6 $761 7 $776 8 $792 9 $811 10 $832 We can observe from the above tables that the mounting interest rate mitigates the value of the bonds. We can say that the municipal bonds have the lowest interest rate that's why its bond value is the highest as compared with the value of corporation and convertible bonds. With respect to these things we can say that the municipal bonds are the less risky ones, while the corporation bonds are much riskier as compared with others. YIELD TO MATURITY: Investors are merely concerned over the return of the investment. The high the yield, high will be the return of the investors on his investment. More precisely we can say that, what rate of interest would an investor earn on his investment if he bough the bond and held it to maturity. The rate which receives by the investor on his investment over a specified period of time is known as yield to maturity. We have calculated the yield to maturity of all the bonds, let's compare the result and see which one's yield is dominating. Municipal Bonds: Years to Mat: 10 Coupon rate: 5% Annual Pmt: $100.00 Going rate, r =YTM: 6.93% Current price: $1,216.00 Par value = FV: $1,000.00 Convertible Bonds: Years to Mat: 10 Coupon rate: 10% Annual Pmt: $100.00 Going rate, r =YTM: 10.00% Current price: $1,000.00 Par value = FV: $1,000.00 Corporation Bonds: Years to Mat: 10 Coupon rate: 15% Annual Pmt: $100.00 Going rate, r =YTM: 13.11% Current price: $832.00 Par value = FV: $1,000.00 From, the table above we, can say that the yield to maturity of corporation bonds is dominating with the highest percentage of 13.11%, followed by convertible and municipal bonds by 10% and 6.93% respectively. CONCLUSION: From the above controversial matter, we can say that, issuance of bonds is a reasonable tool to enhance the equity of a corporation. We can say that bonds are the safest investment among a number of investments in which the appetite of risk is comparatively on the lower side. Bonds is one of the most famous investment in the United States, as it comes in many shapes and flavors, with new varieties introduced each year. REFERENCES: Vernimmen, P (2000), Corporate Finance Theory and Practice, British Library Publications. Cinnamon, R & Larsen, B.H (2006), How to understand Business Finance, British Library Publications. Read More