Understanding Bonds: Types, Risks, and Accrued Interest Explained
The terms bond, debenture, obligation, fixed-income security, and bond are used synonymously for securities that represent interest-bearing claims of the buyer against the issuer. For the issuer, these represent liabilities on their balance sheet.
The holder of the bond is entitled to:
- Interest payment (“coupon”)
- Principal repayment
Potential issuers of bonds include public budgets (federal, state, and local governments), credit institutions, and private companies.
The maturities of bonds can range from short-term (less than 4 years) to perpetual bonds (no fixed maturity).
The interest on a bond is traditionally referred to as a “coupon” and can be paid in two ways: (1) Coupon bonds with nominal interest rates and zero-coupon bonds.
Coupon bonds can have a fixed nominal interest rate (straight bond) or a variable nominal interest rate (floating rate notes, or floaters). Interest is usually paid annually.
In contrast, zero-coupon bonds (zero bonds) do not have interest payments during their term. The interest income is derived from the difference between the issue price and the repurchase price.
Digression: Convertible Bond
Convertible bonds are debt securities that give the holder the right to convert the bond into shares. The conversion right must be specified in the terms of the convertible bond:
- Conversion ratio
- Conversion period
- Possible additional payments From the above conditions, a conversion price is calculated.
The right to convert can be exercised during the conversion period. If this right is not claimed, the convertible bond is redeemed like a regular bond.
Until the conversion, convertible bonds represent cheap liabilities for the issuer, as the interest rate is often slightly lower than for bonds without conversion rights. By converting a bond into shares, the debt is transformed into balance sheet equity.
Convertible bonds are opposed by so-called equity-linked bonds, also known as “reverse convertibles.” These work in reverse, as the issuer now has the right to deliver shares instead of repaying the principal.
Risks of Bonds
Bonds are primarily subject to two risks that should be considered before investing in these instruments.
Default / Credit Risk
The issuer’s creditworthiness is crucial in determining whether they can meet their principal repayment obligations when the bond matures. In case of the issuer’s insolvency, the secured claim is at risk of default.
Interest Rate Risk
Bonds are subject to interest rate risk when market interest rates rise. As market interest rates rise, the lower fixed nominal interest rate of the bond does not change. As a result, bond prices fall.
Besides the mentioned risks, depending on the bond, there may be additional risks, such as redemption risks, draw risks, or conversion risks.
Accrued Interest
When interest-bearing securities are sold during their term, the seller is entitled to all interest accrued up to that point. This also applies to the pro-rata interest accrued during the period between the last interest payment and the sale (accrued interest).
The buyer of the bond pays this pro-rata interest, which is then transferred to the seller. The period for accrued interest begins with the last interest payment date and ends, inclusive, the day before settlement (accrued interest value date).
Accrued Interest Value Date = Transaction Day + 2 Trading Days – 1 Calendar Day
Examples:
Transaction Day = Thursday, September 15 ⇨ Accrued Interest Value Date = Sunday, September 18
Transaction Day = Monday, September 12 ⇨ Accrued Interest Value Date = Tuesday, September 13
Depending on the interest calculation method specified in the bond conditions, the amount of accrued interest is determined based on the number of days between the last interest payment and the accrued interest value date, the interest rate, and the nominal amount.