What is a bond?

A bond is a financial instrument that allows companies, government institutions or other organisations to raise funds from investors to finance their projects or activities. In return, the issuer of the bond undertakes to repay the amount borrowed to the investor, together with a pre-agreed interest rate, within a certain period of time. Bonds are a relatively safe form of investment because they have a predetermined yield and maturity date. In this article, we will explain in more detail how bonds work, what types of bonds exist, and why they are an important part of the financial markets.

What is a bond?

A bond is a security that represents an obligation of the issuer (the borrower) to the bondholder (the lender). Essentially, it is a form of loan where the issuer raises funds from investors with an obligation to repay the face value of the bond together with an agreed interest within a specified time frame. This interest is called a coupon and represents the remuneration to the investor for providing the capital.

Legally, a bond is a legal obligation between the issuer and the investor. The issuer may be a private company, a public institution, a municipality or a state. The terms of the bond, such as the maturity, the amount of the coupon and the method of payment of interest, are predetermined and specified in advance in the terms of issue.

Bonds are a key instrument for financing long-term projects and operational needs, providing investors with a lower-risk alternative to other forms of investment, such as equities. However, the level of risk can vary from issuer to issuer, which is why issuer ratings from reputable agencies are important for investors to help assess the issuer’s ability to meet its obligations.

Bonds are often used as a portfolio diversification tool because they have a relatively stable yield and lower volatility compared to equities, but also provide a higher yield than traditional bank deposits.

What are government bonds?

Government bonds are bonds issued by a national government or other public institution to raise funds to finance various public projects, cover budget deficits or refinance existing debt. They are essentially a form of borrowing, with the government acting as the borrower and the investors who purchase these bonds as the lenders.

From an investor’s point of view, government bonds are considered one of the safest forms of investment because the risk of default (called credit risk) is very low, especially for bonds issued by stable and economically strong countries. This low risk stems from the fact that the government has the ability to generate revenue through taxes or by issuing more bonds to pay its obligations.

Government bonds can have different maturity lengths:

1. Short-term bonds – with a maturity of up to one year, often referred to as treasury bills.
2. Medium-term bonds – maturing between one and ten years, such as treasury notes.
3. Long-term bonds – with a maturity of more than ten years, known as treasury bonds.

The yield on government bonds may be fixed in the form of regular coupon payments or may depend on inflation or other economic indicators.

The advantage for the investor is a stable and predictable return, while the government receives the necessary financing on favourable terms. Government bonds also play an important role in a country’s macroeconomic policy, as they allow governments to influence interest rates and monetary policy. In the international financial market, government bonds are a liquid asset and often serve as a benchmark for setting interest rates for other types of bonds and loans.

Basic concepts in bonds

There are a number of key terms used in bonds that help investors understand how these financial instruments work. Here are the basic terms that are essential to understanding bonds:

• Bond: a security that represents an obligation of the issuer to the investor. The bond promises to pay interest (coupons) to the bondholder over the life of the bond and to return the face value at maturity.
• Issuer: the entity issuing the bond. The issuer may be a government, a local authority, a public body or a private company. The issuer undertakes to pay the bondholder interest and the face value of the bond at maturity.
• Par value (face value): the amount that the issuer will pay to the bondholder at maturity. The face value is usually set at the time of issue and also serves as the basis for calculating interest payments.
• Coupon: a periodic interest payment made by the issuer of a bond to the holder. The coupon is usually set as a percentage of the face value of the bond. For example, if a bond has a nominal value of EUR 1 000 and a coupon of 5 %, the investor receives EUR 50 per year.
• Coupon rate: the percentage rate used to calculate the amount of regular coupon payments. It is the proportion of the nominal value of the bond that the issuer pays to the investor each year as interest.
• Maturity: the date on which the issuer must return the face value of the bond to the investor. Maturity can be short-term (up to one year), medium-term (between one and ten years) or long-term (over ten years).
• Bond yield: the yield is the rate of return on an investment in a bond. It can be calculated in various ways (e.g. yield to maturity – YTM, current yield)
• Market price of a bond: the price at which a bond is traded on the secondary market. This price may differ from the face value of the bond depending on interest rates, demand for bonds and the creditworthiness of the issuer.
• Discount bond: a bond that trades at a price below its face value. The investor thus profits not only from the coupon payments but also from the difference between the purchase price and the face value, which will be paid to him at maturity.
• Credit rating: an assessment of an issuer’s ability to repay its obligations. Credit ratings are issued by credit rating agencies such as Moody’s, Standard & Poor’s and Fitch. A higher credit rating indicates a lower risk of default of the issuer, a lower rating indicates a higher risk.

Bond vs. share (what is the difference)

In short, the difference between a bond and a stock:

Equity vs. debt instrument:

• A bond is a debt instrument: the investor lends money to the issuer (government, corporation) for a certain period of time and receives regular interest (coupon). When the bond matures, the issuer pays back the principal.
• A share is an ownership instrument: by buying a share, the investor acquires a share in the company’s assets, which means that he is a co-owner of the company.

Yield:

• A bond provides a regular income in the form of interest, which is usually fixed, and a return of principal at maturity.
• A stock may yield dividends (if the company pays them), but the main profit comes from the increase in the share price in the market.

Risk:

• Bonds are generally less risky than equities because investors receive a fixed return and have priority in liquidating a firm’s assets in the event of bankruptcy.
• Stocks are riskier because the value of a stock can fluctuate and investors can lose their entire investment when a company goes bankrupt.

Priority rights:

• Bonds have a higher priority for redemption in bankruptcy than shares.
• Shareholders are paid only after all creditors, including bondholders, have been satisfied.

Basically, bonds offer more stability and lower yield, while equities offer the potential for higher returns but with higher risk.

Types of bonds

Bonds can be divided into several categories based on different criteria such as issuer, maturity, interest terms and interest payment method. Here are the most important types of bonds:

By issuer

• Government bonds (government bonds): issued by the government or other public institutions to finance government projects or cover budget deficits. This includes, for example, US Treasury bonds, German Bunds or Slovak government bonds.
• Corporate bonds (corporate bonds): issued by private companies to finance their activities, investments or projects. Their risk is generally higher than that of government bonds and therefore they provide a higher yield.
• Municipal bonds: issued by municipalities, cities or other public entities at the local level. The proceeds of these bonds may be tax-exempt in some countries.
• International bonds: issued by supranational organisations such as the World Bank or the European Investment Bank. These are used to finance projects in different countries.

By maturity

• Short-term bonds: maturing within one year, such as treasury bills.
• Medium-term bonds: with maturities of between one and ten years, such as corporate or government bonds.
• Long-term bonds: those with a maturity of more than ten years, such as treasury bonds.

By interest rate

• Fixed-rate bonds: have a fixed interest rate that does not change over the life of the bond. Investors receive regular coupon payments equal to this rate.
• Floating-rate bonds: the interest rate varies according to a predetermined indicator, such as the interbank offered rate(LIBOR).
• Zero-coupon bonds do not issue regular coupons. The investor’s profit is the difference between the purchase price and the face value at maturity.

By nature of repayment

• Amortising bonds: the principal (principal) is repaid at regular intervals over the life of the bond, not just at maturity.
• Single repayment bonds: the entire principal is repaid at once when the bond matures.

Under special conditions

• Convertible bonds: allow the holder to convert the bond into shares of the issuing company under predetermined conditions.
• Collateralised bonds: are guaranteed by an asset, such as real estate or other assets of the issuer. In the event of a default on the bond, the investor can collect the asset.
• Subordinated bonds: in the event of liquidation or bankruptcy of the issuer, they have lower priority in satisfying claims than other creditors. They are therefore riskier, but generally offer a higher yield.
• Inflation-linked bonds: their yield is indexed to the rate of inflation, thus providing investors with protection against a decline in purchasing power.

Special types

• Exchangeable bonds: similar to convertible bonds, but the holder has the option to exchange them for shares of another company, not the issuer.
• Structured bonds: have a more complex yield or maturity structure and are often linked to derivatives or other financial instruments.

How do bonds work?

Bonds function both as a financing instrument and as an investment vehicle that intermediates capital between the issuer and the investor. From an economic point of view, the functioning of bonds involves a number of key mechanisms:

Issuing a bond

A bond begins its life when an issuer (e.g., a government, corporation, or municipality) issues bonds in the public or private market to raise funds. By issuing a bond, the issuer is essentially indebted to the investor who purchases the bond. The issuer thereby undertakes to repay the nominal value of the bond (called the principal) and at the same time to pay regular interest (coupon) until the maturity of the bond.

Interest (coupon)

A bond usually contains a coupon rate, which is a percentage of the face value of the bond and which is paid periodically by the issuer to the investor. Coupons may be paid monthly, quarterly, semi-annually or annually. Fixed-rate bonds have a fixed coupon rate, while variable-rate bonds can vary their interest rate depending on market conditions (e.g. according to a benchmark interest rate).

From an economic perspective, coupons provide investors with a regular income, which means that bonds can be attractive to those who prefer stable returns.

Maturity and return on investment

Each bond has a stated maturity date on which the issuer undertakes to return the face value of the bond to the investor. The economic return to the investor consists of regular coupon payments over the life of the bond and a final principal payment at maturity.

Market price of the bond

The price of a bond in the secondary market can fluctuate depending on various economic factors such as interest rates, inflation, the credit risk of the issuer and the general state of the economy. If interest rates rise in the market, the price of existing bonds (with lower coupon rates) falls because new bonds offer a higher yield. Conversely, when interest rates fall, the price of bonds rises.

This operation makes economic sense from a liquidity point of view. Investors can sell bonds on the secondary market before they mature, thereby raising immediate capital, but the price they receive may be lower or higher than the face value of the bond.

Risk and return

Economically, bond risk is primarily linked to the creditworthiness of the issuer and market conditions. The higher the risk that the issuer will default on its obligations, the higher the yield bonds must offer to attract investors. Bonds issued by governments of stable countries (e.g. USA, Germany) have a low default risk, which means that they offer lower yields. On the other hand, corporate bonds or bonds from issuers with lower credit ratings may offer higher yields but are riskier.

The role of bonds in the economy

From a macroeconomic perspective, bonds play a key role in public debt management and the financing of public projects. Governments often issue bonds to cover budget deficits or infrastructure investments. Bonds also serve to manage monetary policy, as central banks can buy and sell government bonds to control the money supply and interest rates in the economy.

Inflation and real yields

Inflation has a large impact on the real value of bond yields. If inflation rises, the real yield on a fixed-rate bond falls because coupon payments have less purchasing power. Inflation-linked bonds, on the other hand, are linked to inflation, which provides protection against rising prices.

How do bond scams work?

Bond scams are illegal activities where investors are deceived into buying or trading bonds. These scams can take various forms and often involve misleading information, fake bonds or illegal price manipulation.

Basic bond scams include:

• Selling fake bonds: one of the simplest forms of fraud is the sale of non-existent or fake bonds. Fraudsters create fake documents that look like legitimate bonds from known issuers (governments, corporations or other entities) and then sell them to investors. Fraudsters convince investors that the bonds are legitimate, often promising high returns. After the sale, the scammers disappear, with investors realising too late that the bonds they bought have no value.
• Bond-based Ponzi scheme: in a Ponzi scheme, money from new investors is used to pay returns or “profits” to previous investors, creating the illusion of a legitimate return. In the context of bonds, a Ponzi scheme can be disguised as a legitimate bond investment programme that promises stable and high returns.
• Misleading information about bonds: some scammers sell legitimate bonds but lie about their true terms, such as the issuer’s credit rating, yield or risk. Investors are deliberately misled about the safety of the bond or the likelihood that the issuer will repay its obligations.
• Insider trading: insider trading is the illegal practice whereby a person with access to non-public information about a bond issuer (for example, about an impending bankruptcy or a large merger) uses that information to buy or sell bonds before the information becomes public. This activity is illegal because it puts ordinary investors, who do not have the same access to information, at a disadvantage.

The most notorious bond scams

There have been several major bond frauds in the history of financial markets that have had a significant impact on investors, financial institutions and regulators. These cases show how bonds can be used for financial fraud and the consequences this can have for the markets and the public.

1. Drexel Burnham Lambert and Michael Milken’s Bond Scam (1980s)

Michael Milken, often referred to as the “King of Junk Bonds”, worked for the investment bank Drexel Burnham Lambert and was one of the key figures in the development of the junk bond market. Milken used these high-yielding but risky bonds to finance many businesses and mergers. Although junk bonds are a legitimate financial instrument, Milken and Drexel Burnham Lambert have been accused of various illegal business practices, including market manipulation and bond fraud. Milken and Drexel Burnham Lambert manipulated the market for high-risk junk bonds, often through unethical practices such as insider trading, harming ordinary investors and increasing market risks. Milken was sentenced to prison in 1990 on various fraud-related charges, and his practices triggered the collapse of Drexel Burnham Lambert. The bank declared bankruptcy in 1990, leading to massive losses for investors and damaging the junk bond market.

2. Enron’s Huge Fraud (2001)

The Enron fraud is one of the biggest corporate scandals in history. Enron, formerly an energy company, became embroiled in a vast web of fraudulent financial practices, including creating fake bonds and hiding real financial liabilities off its balance sheet. Enron used derivatives and bonds to hide its true debts and report false profits, deceiving investors about the company’s financial condition. Enron created a complex web of shell companies (“special purpose entities“) that it used to issue fake bonds and hide its real liabilities. In this way, they misrepresented their financial position and misled investors. When the fraud was exposed in 2001, Enron collapsed and investors lost billions of dollars. The Enron scandal triggered significant changes in the regulation of financial markets, including the passage of the Sarbanes-Oxley Act, which increased the accountability of corporate management for financial reporting.

3. Madoff’s Ponzi scheme (2008)

Bernard Madoff, one of the most notorious financial fraudsters, ran a massive Ponzi scheme that harmed thousands of investors over several decades. Madoff defrauded investors by pretending to invest their money in bonds and other financial instruments. In reality, however, he used the new contributions to pay out older investors, creating the appearance of high returns. Madoff claimed to manage a portfolio of bonds and other securities that generated stable and high returns. In reality, however, he was not investing this money, but was using contributions from new investors to pay off older investors, a typical Ponzi scheme. In 2008, during the financial crisis, the scam fell apart and Madoff was arrested. It is estimated that his Ponzi scheme caused losses of around USD 65 billion. Madoff was sentenced to 150 years in prison in 2009. This fraud has increased the emphasis on transparency and oversight in the investment company sector.

4. Lehman Brothers (2008)

Lehman Brothers was one of the largest investment banks in the US and collapsed during the 2008 financial crisis. One of the causes of its collapse was high-risk bonds and mortgage-based derivatives, which collapsed when the housing market crashed. Lehman Brothers also lied about the extent of its risky investments, leading to massive losses for investors. Lehman Brothers engaged in high-risk trading in bonds that were backed by defaulted mortgages. The bank used various accounting tricks to hide the real risk, which eventually led to its downfall. Lehman Brothers declared bankruptcy in September 2008, causing a profound shock to the world’s financial markets and precipitating the global financial crisis. This collapse demonstrated the need for better risk management and transparency in financial institutions.

In conclusion

Bonds are an important financial instrument that serve as a stable and reliable investment option for those seeking a regular return and a lower level of risk compared to equities. Investors can choose from a variety of bond types, from government to corporate, with each type offering different yields and risk profiles. Although bonds are considered a more conservative investment option, they carry certain risks such as credit risk and the impact of interest rates. To invest successfully in bonds, it is therefore crucial to understand the basic concepts, the mechanics of how bonds work and to carefully consider the factors that affect their value.