Bonds – also known as debt instruments or fixed-income securities – are interest-bearing securities used for the medium to long-term debt financing of companies and governments. They embody the right to repayment and to be paid interest at a certain rate in exchange for providing the capital. The payable interest rate depends, above all, on the borrower’s creditworthiness.
Whereas investors who buy shares become (co-)owners of a company, bondholders are creditors. Unlike loans, bonds are normally issued publicly, so that anyone can provide the bond issuer with capital for the tenor of the bond.
The most common internal structures for bonds are as convertible bonds or hybrid bonds. A convertible bond is usually an interest-bearing security at a nominal rate of interest which gives the holder the right, during a conversion period, to convert the bond into shares of the issuing company in a predetermined ratio. A hybrid bond is an equity-like subordinated corporate bond with a very long maturity or an unlimited maturity. It can be redeemed by the issuer after a predetermined date. Also, the agreed coupon payments can be suspended or deferred under certain conditions. Hybrids carry a higher rate of interest compared to conventional corporate bonds, to reward investors for the increased risk which can even lead to the total loss of the amount invested – if the issuer goes bankrupt, for example.
Bonds differ from one another essentially with regard to the method of interest payment and in terms of their internal structure. The most common interest payment methods are as follows: In the case of fixed-income bonds, creditors receive a regular – mostly annual – interest payment, which has been agreed in advance. Bonds in this common form are also called plain vanilla bonds, due to their simple format. Floating-rate bonds (so-called floaters) generate interest income at a variable rather than a fixed rate. The respective interest rate is often based on money market rates such as Libor, the London Interbank Offered Rate, or Euribor, the European Interbank Offered Rate, plus the issuer’s risk premium.