In the next few minutes:
Both are debt. A loan is a private agreement between a borrower and a lender, and it can't be traded. A bond (a fixed-income security) is a standardised debt security that investors can trade.
A bondholder lends the issuer the principal. The issuer promises interest, usually as a regular coupon, and the principal back at the end.
For a corporate issuer, loans and bonds sit on the balance sheet as long-term liabilities.
The issuer is the borrower. The biggest are:
Others include local governments, supranational entities (such as the IMF), quasi-government entities (such as a national railway) and special purpose entities (SPEs). An SPE buys financial assets and issues asset-backed securities (ABS), bonds paid from those assets' cash flows.
The maturity date is when the final cash flow is paid. The time left until then is the bond's tenor.
Original maturity sorts bonds:
| Original maturity | Market |
|---|---|
| 1 year or less | Money market securities |
| More than 1 year | Capital market securities |
| None stated | Perpetual bonds |
Par value (principal, face value) is the amount repaid, usually at maturity. Some debt, such as a mortgage, repays principal gradually instead.
The coupon rate is the annual percentage of par paid as interest. Divide by the number of payments a year:
Our bond: 5-year, 1,000 par, 5% coupon, paid semiannually.
Each coupon = 5% × 1,000 ÷ 2 = 25, paid every six months.
The coupon is based on par, never on the price.
A floating-rate note (FRN) pays a variable rate: the market reference rate (MRR) plus a fixed margin. Margins are quoted in basis points (bp); 1 bp = 0.01%.
If MRR is 3.00% and the margin is 150 bp, this period's rate is 3.00% + 1.50% = 4.50%.
A zero-coupon bond (pure discount bond) pays no coupons. It sells below par, and all its interest comes from receiving par at maturity.
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If the issuer is liquidated, debt is paid before equity. Debt is senior to equity.
Not all debt ranks equally. Senior debt is paid before junior (subordinated) debt. That makes senior debt less risky, so junior bonds must offer investors higher yields to compensate for the greater risk of loss.
A contingency provision gives someone the right to act if a future event happens. In bonds, these are embedded options:
Later readings cover how each one works.
A bond's yield is the expected return from buying it at today's price and receiving its promised cash flows.
The cash flows of a fixed-coupon bond are fixed. The only way it can offer a higher return is a lower price. So price and yield move inversely.
Take a bond that pays 1,000 in one year. Slide the yield:
Bonds from one issuer with different maturities usually offer different yields. Plot yield against maturity and you get a yield curve.
Upward-sloping, the shape seen most often. Investors want more return for the greater uncertainty of longer maturities.
Government bonds are backed by the government's power to tax, so they're usually the lowest credit risk in their market. Their yield curve is the benchmark.
The extra yield a riskier issuer offers over the benchmark of the same maturity is its spread:
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The bond indenture (also called the trust deed) is the legal contract between the issuer and its bondholders. It sets out the issuer's obligations and the restrictions on it.
It specifies:
Where the money to pay bondholders comes from depends on the issuer:
| Issuer | Repaid from |
|---|---|
| Sovereign | Taxes; sometimes new currency |
| Local government | Local taxes or project revenue, such as tolls |
| Corporate | Operating cash flow |
| ABS | Cash flows of the SPE's financial assets |
A sovereign's taxing power is why its debt is seen as the lowest credit risk in its region.
Both are repaid from the company's operating cash flow. The difference is what happens on default.
Bonds carry no votes, so bondholders protect themselves with covenants in the indenture. Affirmative covenants say what the issuer must do:
Negative covenants restrict the issuer. Typical limits on:
They cut default risk, but covenants that are too strict stop the issuer responding to opportunities.
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Check yourself
| Feature | Key point |
|---|---|
| Maturity | 1 year or less: money market |
| Coupon | Coupon rate × par ÷ payments per year |
| Seniority | Senior before junior, debt before equity |
| Yield | Moves opposite to price |
| Spread | Yield minus same-maturity government yield |
| Indenture | The contract, including covenants |
| Covenants | Affirmative: must do. Negative: must not do |
That's the reading.
Now test it on exam-style questions while it's fresh.