A debt security is a financial instrument representing a borrower’s obligation to repay funds received from a lender, and if the security’s maturity exceeds one year, it’s referred to as a bond. This obligation includes a repayment schedule and the lender’s compensation, which can be fixed or linked to an index, making it variable. Unlike traditional bank loans, debt securities can be traded on secondary markets like stock exchanges and money markets, though the underlying principles are similar. Examples include bonds, commercial paper, Treasury bills, and mortgage-backed securities. The rise of bond markets was driven not only by disintermediation but also by the growing difficulty of securing bank loans, as banks found the returns insufficient, leading companies to seek funding through bonds instead.

1. BASICS

The principal

Publicly tradable loans are divided into units, each with an equal share of the debt, known as the nominal, face, or par value. This value is typically €1,000 for bonds, though it can vary; for example, the nominal value for a specific bond might be €50,000. The nominal value is important as it is used to calculate interest payments, represents the amount received by the issuer per bond, and is also the amount repaid upon maturity. The issue price is the price at which bonds are sold to investors and can vary: it may be higher than the nominal value (issued at a premium), lower (issued at a discount), or equal (issued at par). For instance, if a bond is issued at 99.532% of its nominal value, it is sold at a discount. Redemption occurs when a bond is repaid, and it can happen in various ways: at maturity (bullet repayment), in equal installments (constant amortization), or in fixed installments. Bonds may also include options for early redemption, such as call options for the issuer or put options for the bondholder, though not all bonds offer these features. A redemption premium or discount arises when the redemption value differs from the nominal value. Bond maturity refers to the time from issuance to final redemption, with average maturity calculated based on all repayment periods for bonds paid in installments. Guarantees for bond repayment can come from the issuer, a parent company, or occasionally from collateral, such as mortgages. However, bonds are rarely secured, unlike commercial paper or certificates of deposit, which theoretically can be secured but usually are not.ù

The income

The issue date of a bond marks the beginning of interest accrual, which might not align with the settlement date when investors actually pay for the bonds. Interest on a bond typically starts accruing on the settlement date. The coupon rate, or nominal rate, determines the interest payments to bondholders. This is calculated by multiplying the coupon rate by the bond’s par value. For instance, if a bond has a coupon rate of 4.25% and a par value of €50,000, the annual coupon payment would be €2,125. If the bond is purchased at a discount, below its par value, investors may benefit from additional returns.

Coupon payments can be made annually, semi-annually, quarterly, monthly, or at other intervals. Zero-coupon bonds, however, do not make periodic interest payments; instead, interest is compounded and paid only at redemption. Typically, interest is paid at the end of the period it covers, though some bonds may prepay interest. Generally, the bond in question pays accrued interest on an annual basis.

2. YIELD TO MATURITY

The actual return on an investment (or the borrower’s loan cost) depends on several factors: the time between the settlement date and the issue date, any issue premium or discount, redemption premium or discount, deferred redemption periods, and the coupon payment interval. Due to these variables, the nominal rate alone is not very indicative.

As discussed already, the yield to maturity equates the bond’s present net value with the difference between the issue price and the present value of future cash flows. For bonds, the yield to maturity (y) and the internal rate of return are the same. This yield is calculated on the settlement date when investors pay for their bonds and is always listed in the bond issue prospectus. It accounts for any differences in timing between earning income and receiving actual payments.

The yield to maturity, before taxes and intermediary fees, represents:

• For investors, the rate of return they would earn by holding the bonds until maturity, assuming that interest payments are reinvested at the same yield, which is a strong assumption.
• For the issuer, the pre-tax actuarial cost of the loan.

From the investor’s perspective, the bond’s schedule must consider intermediation costs and tax implications. For the issuer, the gross cost to maturity is higher due to commissions paid to intermediaries, which increases the borrowing’s actuarial cost. Additionally, the issuer pays intermediaries responsible for disbursing interest and repaying the principal. However, the issuer can deduct coupon payments from corporate income taxes, reducing the loan’s actual cost.

Spreads

The spread represents the difference between the yield on a bond and the yield on a market benchmark. In the euro area, the benchmark for long-term debt is typically the Interest Rate Swap (IRS) rate, though sometimes the spread to government bond yields is also used. For floating-rate bonds and bank loans, the spread is measured against a short-term rate like the three- or six month Euribor in the eurozone. The spread is essential for valuing bonds, particularly at issuance because it reflects the perceived credit quality of the issuer and the maturity of the bond, as indicated by the credit rating and any guarantees. Spreads are relative and depend on the bonds being compared. A stronger issuer creditworthiness and higher market risk appetite result in a lower margin.

The secondary market

Once the subscription period ends, the issue price becomes irrelevant as the bond’s value starts fluctuating on the secondary market. Consequently, the yield to maturity mentioned in the prospectus only applies at the time of issue; it will change as the bond’s value fluctuates. In theory, these fluctuations in yield to maturity on the secondary market don’t directly affect the borrower since the debt cost was locked in when the bond was issued.

3. FLOATING-RATE BONDS

Up to this point, we’ve focused exclusively on fixed-income debt securities, where the cash flow schedule is clearly defined at issuance. However, the securities discussed in this section generate cash flows that aren’t entirely fixed from the start but instead follow predetermined rules.

The coupon of a floating-rate bond isn’t fixed but is tied to a market rate, usually a short-term rate like the six-month Euribor. Essentially, the coupon rate is periodically adjusted based on a reference rate plus a spread. Each coupon payment is calculated using the formula:

This structure eliminates interest rate risk for the issuer, who always pays the market rate, and ensures that the investor receives a return in line with current market conditions. As a result, the price of a floating-rate bond generally stays close to its par value unless concerns about the issuer’s solvency arise.

Consider a simple example of a fixed-rate bond indexed to the one-year rate, which pays interest annually. The day after a coupon payment is made, and with one year remaining until maturity, the bond’s price, as a percentage of its par value, can be calculated using the formula:

Here, r1 represents the one-year rate. In this scenario, the bond price is 100% of its par value because the discount rate is the same as the rate used to calculate the coupon. Similarly, it can be demonstrated that the bond’s price remains at 100% on each coupon payment date. Between coupon payment dates, the bond’s price will fluctuate like a short-term instrument.

If the reference rate applies to a period that differs from the interval between coupon payments, the calculation becomes slightly more complex. However, since short-term rates generally do not vary significantly, the bond’s price won’t fluctuate much over time. The primary factor that could cause a floating-rate bond’s price to fall significantly below its par value is a decline in the issuer’s creditworthiness. Therefore, while floating-rate bonds may not always be exactly at 100%, they are not highly volatile.

4. THE VOLATILITY OF BONDS

Debt security holders face three primary risks: interest rate risk, coupon reinvestment risk, and credit risk. Interest rate risk is particularly pertinent to fixed-rate securities; when market interest rates rise, the prices of these bonds fall because newer bonds offer higher yields, making existing bonds less attractive. Conversely, when market rates fall, bond prices increase as existing bonds with higher rates become more desirable. Coupon reinvestment risk arises from the uncertainty about the rates at which bond coupons can be reinvested. If interest rates rise, investors can reinvest coupons at higher rates, but if rates fall, reinvestment yields drop. Zero-coupon bonds avoid this risk since they do not provide periodic coupon payments. Credit risk affects all types of securities and involves the possibility that the issuer may default, impacting the bond’s value. To gauge how much a bond’s price will change with interest rate fluctuations, investors use modified duration, which measures a bond’s sensitivity to rate changes. Bonds with longer maturities and lower coupon rates generally exhibit higher sensitivity to interest rate shifts. Additionally, convexity measures how this sensitivity changes with fluctuations in rates, providing insight into the bond’s price behavior beyond simple linear approximations.

V. THE ROLE OF RATINGS

Default risk is assessed through financial analysis or credit scoring, with major rating agencies like Standard & Poor’s, Moody’s, and Fitch providing insights into a borrower’s creditworthiness. These agencies rate companies, banks, sovereign states, and municipalities on their credit quality for both specific issues and overall creditworthiness. They offer ratings with outlooks indicating potential future trends and use modifiers like + or − to refine their assessments. A watchlist alert signals possible rating changes due to upcoming events. Ratings range from investment-grade (AAA to BBB-) to speculative-grade (BB+ to D), a crucial distinction for investors, especially institutions restricted from buying speculative-grade bonds. In Europe, companies typically request ratings to provide detailed information to agencies, who rarely rate firms without management’s cooperation. Companies can also choose confidential or “shadow” ratings if they prefer not to make their rating public immediately.